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, 2007

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 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  x        No   o

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

Large accelerated filer  x

Accelerated filer  o

Non-accelerated filer  o

 

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 1,360,406,581 shares of common stock outstanding at June 30, 2007.

Index

	Pages
Part I - Financial Information:
Item 1. Consolidated Financial Statements
Consolidated Statement of Earnings for the three and six months ended June 30, 2007 and 2006	3
Consolidated Statement of Financial Position at June 30, 2007 and December 31, 2006	5
Consolidated Statement of Cash Flows for the six months ended June 30, 2007 and 2006	7
Notes to Consolidated Financial Statements	8
Item 2. Management’s Discussion and Analysis of Results of Operations and Financial Condition	21
Item 4. Controls and Procedures	51
Part II - Other Information:	51
Item 1. Legal Proceedings	51
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds and Issuer Repurchases of Equity Securities	52
Item 4. Submission of Matters to a Vote of Security Holders	53
Item 5. Other Information	55
Item 6. Exhibits	55

 

2

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)		2007			2006*			2007			2006*
Revenue:*
Services		$	13,072		$	11,918		$	25,495		$	23,508
Sales		10,097			9,392			19,083			17,878
Financing		602			580			1,223			1,164
Total revenue		23,772			21,890			45,801			42,549
Cost:*
Services		9,450			8,624			18,501			17,144
Sales		4,059			3,968			7,867			7,744
Financing		325			284			629			558
Total cost		13,834			12,876			26,997			25,447
Gross profit		9,938			9,014			18,804			17,102
Expense and other income:
Selling, general and administrative		5,631			4,916			10,720			9,518
Research, development and engineering		1,534			1,522			3,044			2,977
Intellectual property and custom development income		(246		)	(188		)	(451		)	(418		)
Other (income) and expense		(253		)	(196		)	(432		)	(442		)
Interest expense		130			72			203			138
Total expense and other income		6,796			6,125			13,083			11,774
Income from continuing operations before income taxes		3,142			2,889			5,721			5,328
Provision for income taxes		881			867			1,616			1,598
Income from continuing operations		2,261			2,022			4,105			3,730

 

* Reclassified to conform with 2007 presentation; see Note 1 on page 8 for additional information.

(Amounts may not add due to rounding.)

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

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		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in millions except per share amounts)		2007			2006			2007			2006
Discontinued Operations
Loss from discontinued operations, net of tax		(1		)	(0		)	(0		)	(0		)
Net income		$	2,260		$	2,022		$	4,105		$	3,730
Earnings/(loss) per share of common stock:
Assuming dilution:
Continuing operations		$	1.55		$	1.30		$	2.75		$	2.37
Discontinued operations		(0.00		)	(0.00		)	(0.00		)	(0.00		)
Total		$	1.55		$	1.30		$	2.75		$	2.37
Basic:
Continuing operations		$	1.57		$	1.31		$	2.80		$	2.40
Discontinued operations		(0.00		)	(0.00		)	(0.00		)	(0.00		)
Total		$	1.57		$	1.31		$	2.80		$	2.40
Weighted-average number of common shares outstanding: (millions)
Assuming dilution		1,460.8			1,560.1			1,491.8			1,573.6
Basic		1,437.2			1,538.1			1,468.3			1,551.3
Cash dividends per common share		$	0.40		$	0.30		$	0.70		$	0.50

 

(Amounts may not add due to rounding.)

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

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INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
(UNAUDITED)
ASSETS

(Dollars in millions)		At June 30,  2007			At December 31, 2006
Assets:
Current assets:
Cash and cash equivalents		$	7,010		$	8,022
Marketable securities		3,179			2,634
Notes and accounts receivable — trade (net of allowances of $213 in 2007 and $221 in 2006)		9,956			10,789
Short-term financing receivables (net of allowances of $253 in 2007 and $307 in 2006)		13,390			15,095
Other accounts receivable (net of allowances of $11 in 2007 and $15 in 2006)		941			964
Inventories, at lower of average cost or market:
Finished goods		766			506
Work in process and raw materials		2,082			2,304
Total inventories		2,848			2,810
Deferred taxes		1,794			1,806
Prepaid expenses and other current assets		3,175			2,539
Total current assets		42,293			44,660
Plant, rental machines and other property		37,126			36,521
Less: Accumulated depreciation		22,647			22,082
Plant, rental machines and other property — net		14,479			14,440
Long-term financing receivables		10,243			10,068
Prepaid pension assets		11,378			10,629
Intangible assets — net		2,090			2,202
Goodwill		13,201			12,854
Investments and sundry assets		8,865			8,381
Total assets		$	102,548		$	103,234

 

(Amounts may not add due to rounding.)

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

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INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF FINANCIAL POSITION
(UNAUDITED)
LIABILITIES AND STOCKHOLDERS’ EQUITY

						At June 30,				At December 31,
(Dollars in millions except per share amounts)						2007				2006*
Liabilities and Stockholders’ Equity:
Current liabilities:
Taxes						$	2,314			$	4,670
Short-term debt						20,543				8,902
Accounts payable						6,653				7,964
Compensation and benefits						3,823				4,595
Deferred income						9,359				8,587
Other accrued expenses and liabilities						5,392				5,372
Total current liabilities						48,084				40,091
Long-term debt						14,179				13,780
Retirement and nonpension postretirement benefit obligations						13,217				13,553
Deferred income						2,907				2,502
Other liabilities						7,406				4,801
Total liabilities						85,792				74,728
Stockholders’ equity:
Common stock - par value $0.20 per share and additional paid-in capital						33,374				31,271
Shares authorized: 4,687,500,000
Shares issued: 2007 - 2,035,154,809
		2006 - 2,008,470,383
Retained earnings						55,503				52,432
Treasury stock - at cost						(64,125			)	(46,296		)
Shares: 2007 - 674,748,228
	2006 - 501,987,771
Accumulated gains and (losses) not affecting retained earnings						(7,997			)	(8,901		)
Total stockholders’ equity						16,756				28,506
Total liabilities and stockholders’ equity						$	102,548			$	103,234

 

* Reclassified to conform with 2007 presentation.

  (Amounts may not add due to rounding.)

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

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INTERNATIONAL BUSINESS MACHINES CORPORATION
AND SUBSIDIARY COMPANIES
CONSOLIDATED STATEMENT OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30,
(UNAUDITED)

(Dollars in millions)		2007			2006*
Cash flow from operating activities from continuing operations:
Net Income		$	4,105		$	3,730
Loss from discontinued operations		(0		)	(0		)
Adjustments to reconcile income from continuing operations to cash provided from operating activities:
Depreciation		1,943			1,924
Amortization of intangibles		581			531
Stock-based compensation		361			409
Net gain on asset sales and other		(257		)	(45		)
Changes in operating assets and liabilities, net of acquisitions/divestitures		(274		)	(871		)
Net cash provided by operating activities from continuing operations		6,459			5,677
Cash flow from investing activities from continuing operations:
Payments for plant, rental machines and other property, net of proceeds from dispositions		(1,803		)	(1,708		)
Investment in software		(439		)	(394		)
Acquisition of businesses, net of cash acquired		(241		)	(809		)
Divestiture of businesses, net of cash transferred		310			—
Purchases of marketable securities and other investments		(16,998		)	(13,651		)
Proceeds from sale of marketable securities and other investments		16,602			11,591
Net cash used in investing activities from continuing operations		(2,569		)	(4,971		)
Cash flow from financing activities from continuing operations:
Proceeds from new debt		14,066			214
Payments to settle debt		(1,962		)	(1,288		)
Short-term borrowings/(repayments) less than 90 days — net		171			105
Common stock repurchases		(18,205		)	(5,060		)
Common stock transactions — other		1,967			559
Cash dividends paid		(1,044		)	(776		)
Net cash used in financing activities from continuing operations		(5,008		)	(6,246		)
Effect of exchange rate changes on cash and cash equivalents		112			79
Net cash used in discontinued operations - operating activities		(6		)	(7		)
Net change in cash and cash equivalents		(1,012		)	(5,468		)
Cash and cash equivalents at January 1		8,022			12,568
Cash and cash equivalents at June 30		$	7,010		$	7,100

 

* Reclassified to conform with 2007 presentation.

(Amounts may not add due to rounding.)

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

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Notes to Consolidated Financial Statements

1.               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 2006 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 2006 Annual Report.

In the first quarter of 2007, the company changed the presentation of revenue and cost in the Consolidated Statement of Earnings to reflect the categories of Services, Sales and Financing. Previously, the presentation included Global Services, Hardware, Software, Global Financing and an Other category. In the past, these categories were aligned with the company’s reportable segment presentation of external revenue and cost. However, as the company moves toward delivering solutions which bring integrated software and services capabilities to its clients, the alignment between segments and categories will diverge. Therefore, there are situations where the Services segments could include software revenue, and conversely, the Software segment may have services revenue. The change was made to avoid possible confusion between the segment revenue and cost presentation and the required category presentation in the Consolidated Statement of Earnings.

The change only impacts the format for the presentation of the company’s revenue and cost in the Consolidated Statement of Earnings and does not reflect any change in the company’s reportable segment results or in the company’s organizational structure.  The periods presented in this Form 10-Q are reported on a comparable basis.  The management discussion and analysis of revenue and gross profit from continuing operations will focus on the segment view, as this is how the business is managed and is the best reflection of the company’s operating results and strategy.

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.               In February 2007, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an amendment of FASB Statement No. 115,” which will become effective in 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 recorded in earnings.  The company will adopt this Statement in fiscal year 2008 and is currently evaluating if it will elect the fair value option for any of its eligible financial instruments and other items.

In September 2006, the FASB finalized SFAS No. 157, “Fair Value Measurements,” which will become effective in 2008. 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 will be applied prospectively to fair value measurements and disclosures beginning in the first quarter of 2008 and is not expected to have a material effect on the company’s Consolidated Financial Statements.

In the first quarter of 2007, the company adopted SFAS No. 156, “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140,” that provides guidance on accounting for separately recognized servicing assets and servicing liabilities. In accordance with the provisions of SFAS No. 156, separately recognized servicing assets and servicing liabilities must be initially measured at fair value, if practicable. Subsequent to initial recognition, the company may use either the amortization method or the fair value measurement method to account for servicing assets and servicing liabilities within the scope of this Statement. The adoption of this Statement did not have a material effect on the company’s Consolidated Financial Statements.

In the first quarter of 2007, the company adopted SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments–an amendment of FASB Statements No. 133 and 140,” which permits fair value remeasurement for any hybrid

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financial instrument that contains an embedded derivative that otherwise would require bifurcation in accordance with the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  The adoption of this Statement did not have a material effect on the company’s Consolidated Financial Statements.

The company adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109” (FIN 48) on January 1, 2007. FIN 48 clarifies the accounting and reporting for uncertainties in income tax law. This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. See Note 3 below for additional information, including the effects of adoption on the company’s Consolidated Statement of Financial Position.

3.               As highlighted in Note 2 above, the company adopted the provisions of FIN 48 on January 1, 2007.

The cumulative effect of adopting FIN 48 was a decrease in tax reserves and an increase of $117 million to the January 1, 2007 Retained earnings balance.  Upon adoption, the liability for income taxes associated with uncertain tax positions at January 1, 2007 was $2,414 million.  This liability can be reduced by $458 million of offsetting tax benefits associated with the correlative effects of potential transfer pricing adjustments, state income taxes and timing adjustments.  The net amount of $1,956 million, if recognized, would favorably affect the company’s effective tax rate.  In addition, consistent with the provisions of FIN 48, the company reclassified $1,971 million of income tax liabilities from current to non-current liabilities because payment of cash is not anticipated within one year of the balance sheet date. These non-current income tax liabilities are recorded in Other liabilities in the Consolidated Statement of Financial Position.

Interest and penalties related to income tax liabilities are included in income tax expense. The balance of accrued interest and penalties recorded in the Consolidated Statement of Financial Position at January 1, 2007 was $126 million; of this amount, $95 million was also reclassified from current to non-current liabilities upon adoption of FIN 48.

With limited exception, the company is no longer subject to U.S. federal, state and local or non-U.S. income tax audits by taxing authorities for years through 2000. During the first quarter of 2007, the U.S. Internal Revenue Service commenced its audit of the company’s U.S. income tax returns for 2004 and 2005. The company anticipates that this audit will be completed by the end of 2008.  The company does not anticipate a significant change to the total amount of unrecognized tax benefits within the next 12 months.

For the three month and six month periods ending June 30, 2007, there were no material changes related to tax reserves that impacted the company’s effective tax rate.

4.               The following table summarizes Net income plus gains and (losses) not affecting retained earnings (net of tax):

		Three Months Ended June 30,						Six Months Ended June 30,
(Dollars in millions)		2007			2006			2007			2006
Net income		$	2,260		$	2,022		$	4,105		$	3,730
Gains and (losses) not affecting retained earnings (net of tax):
Foreign currency translation adjustments		259			499			349			637
Prior service costs, net gains/(losses) and transition assets/(obligations)*		262			—			470			—
Minimum pension liability adjustments*		—			1,136			—			1,432
Net unrealized gains/(losses) on marketable securities		65			4			47			(22		)
Net unrealized gains/(losses) on cash flow hedge derivatives		23			(235		)	38			(386		)
Total gains and (losses) not affecting retained earnings		609			1,404			904			1,662
Net income plus gains and (losses) not affecting retained earnings		$	2,869		$	3,425		$	5,009		$	5,392

 

* For additional information, see Note V on page 101 in the 2006 IBM Annual Report.

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5.     Stock-based compensation cost is measured at grant date, based on the fair value of the award, and is recognized as expense 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 June 30,						Six Months Ended June 30,
(Dollars in millions)		2007			2006			2007			2006
Cost		$	45		$	52		$	91		$	108
Selling, general and administrative		123			136			235			258
Research, development and engineering		17			21			37			42
Other (income) and expense		(1		)	—			(1		)	—
Pre-tax stock-based compensation cost		184			209			361			409
Income tax benefits		(76		)	(72		)	(143		)	(145		)
Total stock-based compensation cost		$	107		$	137		$	219		$	264

 

The reduction in pre-tax stock-based compensation cost for the three months ended June 30, 2007, as compared to the corresponding period in the prior year, was principally the result of a reduction in the level of stock option grants ($33 million) offset by an increase related to restricted and performance-based stock units ($9 million).  The reduction in pre-tax stock-based compensation cost for the six months ended June 30, 2007, as compared to the corresponding period in the prior year, was principally the result of a reduction in the level of stock option grants ($41 million) and a reduction related to restricted and performance-based stock units ($6 million). The effects on stock-based compensation cost due to the divestiture of the company’s Printing Systems Division are included in Other (income) and expense above and in the Consolidated Statement of Earnings for the three- and six- month periods ended June 30, 2007.

As of June 30, 2007, the balance of $1,300 million of total unrecognized compensation costs related to non-vested awards is expected to be recognized over a weighted-average period of approximately three years.

There were no significant capitalized stock-based compensation costs at June 30, 2007 and 2006.

6.               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 from continuing operations before income taxes.

For the three months ended June 30:		2007			2006			Yr. to Yr.  Percent  Change
(Dollars in millions)
Retirement-related plans—cost:
Defined benefit and contribution pension plans—cost		$	534		$	521		2.5	%
Nonpension postretirement plans-cost		94			93			1.1
Total		$	628		$	614		2.3	%

 

For the six months ended June 30:		2007			2006			Yr. to Yr. Percent  Change
(Dollars in millions)
Retirement-related plans—cost:
Defined benefit and contribution pension plans—cost		$	1,074		$	1,044		2.9	%
Nonpension postretirement plans—cost		197			193			2.1
Total		$	1,271		$	1,237		2.7	%

 

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The following tables provide the components of the cost/(income) for the company’s pension plans:

Cost/(Income) of Pension Plans

		U.S. Plans						Non-U.S. Plans
For the three months ended June 30:		2007			2006			2007			2006
(Dollars in millions)
Service cost		$	185		$	202		$	145		$	159
Interest cost		647			611			433			391
Expected return on plan assets		(926		)	(905		)	(613		)	(585		)
Amortization of transition assets		—			—			—			(1		)
Amortization of prior service cost		15			15			(31		)	(25		)
Recognized actuarial losses		171			190			222			217
Net periodic pension cost—U.S. Plan and material non-U.S. Plans		92		*	113		*	156		**	156		**
Cost of other defined benefit plans		32			27			42			41
Total net periodic pension cost for all defined benefit plans		124			140			198			197
Cost of defined contribution plans		97			94			115			90
Total retirement plan cost recognized in the Consolidated Statement of Earnings		$	221		$	234		$	313		$	287

 

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

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

		U.S. Plans						Non-U.S. Plans
For the six months ended June 30:		2007			2006			2007			2006
(Dollars in millions)
Service cost		$	373		$	384		$	265		$	313
Interest cost		1,293			1,227			807			770
Expected return on plan assets		(1,852		)	(1,806		)	(1,217		)	(1,143		)
Amortization of transition assets		—			—			(1		)	(2		)
Amortization of prior service cost		30			30			(62		)	(28		)
Recognized actuarial losses		340			393			431			403
Net periodic pension cost—U.S. Plan and material non-U.S. Plans		184		*	228		*	223		**	313		**
Cost of other defined benefit plans		62			55			166			78
Total net periodic pension cost for all defined benefit plans		246			283			389			391
Cost of defined contribution plans		213			192			226			178
Total retirement plan cost recognized in the Consolidated Statement of Earnings		$	459		$	475		$	615		$	569

 

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

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

In 2007, the company expects to contribute to its non-U.S. defined benefit plans approximately $620 million, which is the legally mandated minimum contribution for the company’s non-U.S. Plans. In the first six months of 2007, the company contributed approximately $281 million to its non-U.S. Plans, as compared to $1,550 million contributed in the first six months of 2006.

During the second quarter of 2007, the company initiated changes to the investment strategy of its U.S. defined benefit plan:

·                  The 2007 target asset allocation was modified, primarily by reducing public equity securities and increasing debt securities from 33 percent to 43 percent of total plan assets;

·                  Duration of debt securities was increased; and

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·                  The use of derivatives, including interest rate swaps and swaptions, was increased in the fixed income portfolio to further mitigate the effects of future interest rate changes on the level of pension surplus.

These changes are designed to reduce the potential negative impact that equity markets or interest rates might have on the funded status of the U.S. defined benefit pension plan. These changes are not expected to impact the expected long-term rate of return on assets of 8.0 percent. (See Note V, “Retirement-Related Benefits,” pages 107 through 109 in the company’s 2006 Annual Report for additional information).

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

Cost/(Income) of Nonpension Postretirement Plans

		Three Months Ended June 30,						Six Months Ended June 30,
		2007			2006			2007			2006
(Dollars in millions)
Service cost		$	17		$	15		$	34		$	31
Interest cost		76			73			155			152
Amortization of prior service cost		(15		)	(15		)	(30		)	(31		)
Recognized actuarial losses		4			7			12			15
Net periodic post retirement plan cost — U.S. Plan		82			80			171			167
Cost of non-U.S. Plans		12			13			26			26
Total nonpension postretirement plan cost recognized in the Consolidated Statement of Earnings		$	94		$	93		$	197		$	193

 

The company received a $5.1 million subsidy in the second quarter of 2007 and $14.6 million for the first six months of 2007 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 110 in the company’s 2006 Annual Report.

In addition, the company made a $500 million voluntary cash contribution to the U.S. nonpension postretirement benefit plan in March of 2007. This advance funding is in addition to ongoing contributions of approximately $400 million that will be made in 2007 which will be utilized to pay current year benefits. The $500 million contribution will be used to fund benefit payments in future years.

7.               Periodically, the IBM Board of Directors authorizes funding for use in the company’s  common stock repurchase program. The company repurchases shares on the open market or in private transactions, depending on market conditions. During the three months ended June 30, 2007, the Board of Directors authorized $15.0 billion in additional funds for future repurchases of common stock. This amount was in addition to approximately $1.4 billion for common stock repurchase remaining from a prior Board authorization. The company stated that it may repurchase shares on the open market or in private transactions, including structured or accelerated transactions, depending on market conditions.

The company completed open market share repurchases of approximately 20.5 million shares for $2.1 billion during the three months ended June 30, 2007. Additionally, for the three months ended June 30, 2007, 118.8 million shares were repurchased for $12.5 billion by IBM International Group, a wholly-owned foreign subsidiary of the company (the “Foreign Subsidiary”) under accelerated share repurchase agreements with three banks (the “Accelerated Repurchase”).

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Pursuant to the Accelerated Repurchase agreements, executed on May 25, 2007, the Foreign Subsidiary paid an initial purchase price of $105.18 per share for the repurchase. The initial purchase price is 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 will also reflect 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 can be settled in cash, registered shares or unregistered shares at the Foreign Subsidiary’s option. Under the Accelerated Repurchase agreements, the Foreign Subsidiary will have a separate settlement with each of the three banks; these settlements are expected to occur in September 2007, December 2007 and March 2008. Any amounts paid or received by the Foreign Subsidiary under any of the settlement alternatives in connection with the price adjustment will be recorded as an adjustment to Stockholders’ equity in the Consolidated Statement of Financial Position on each of the settlement dates.

The Foreign Subsidiary could be required to deliver a maximum of 356.5 million shares if it elects the share settlement options. The estimated fair value of the cash settlement and share settlement alternatives under the Accelerated Repurchase as of June 30, 2007 would result in the receipt of approximately $225 million or 2.1 million refund shares, respectively, by the Foreign Subsidiary. In comparison, each $1 increase/decrease  in the volume weighted average share price (average from June 1 to June 30, 2007) would impact these estimates by approximately $119 million or approximately 1.1 million shares under the cash settlement and share settlement alternatives, respectively. For the quarter and six months ended June 30, 2007, the effect of the share settlement alternatives would have been antidilutive, and, therefore, were not included in the computation of diluted earnings per share for the respective periods.

On May 25, 2007, the Foreign Subsidiary entered into a 364-day, $11.5 billion floating rate Term Loan Agreement with a number of financial institutions in order to finance the Accelerated Repurchase. This debt issuance is recorded in Short-term debt in the Consolidated Statement of Financial Position.

8.               During the first six months ended June 30, 2007, the company completed four acquisitions at an aggregate cost of $251 million. All four of the acquisitions were completed in the first quarter. In the second quarter, the company announced two acquisitions, Telelogic AB and Watchfire Corporation. The Watchfire acquisition closed in July and the Telelogic acquisition is expected to close in the fourth quarter. Both acquisitions will be integrated into the company’s software segment.

The Software segment completed two acquisitions in the first quarter:  Consul Risk Management International BV. and Vallent Corporation, both privately held companies. Each acquisition further complemented and enhanced the company’s portfolio of product offerings.

Global Technology Services (GTS) completed two acquisitions in the first quarter: Softek Storage Solutions Corporation  and DM Information Systems, Ltd. (DMIS), both privately held companies. Softek augments the company’s unified data mobility offerings and worldwide delivery expertise for managing data in storage array, host and virtualized IT environments. DMIS will enhance and complement the company’s Technology Service offerings.

Purchase price consideration was paid all in cash. These acquisitions are reported in the Consolidated Statement of Cash Flows net of acquired cash and cash equivalents.

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The table below reflects the purchase price related to these acquisitions and the resulting purchase price allocations as of June 30, 2007.

		Amortization
(Dollars in millions)		Life (yrs.)		Acquisitions
Current assets				$	80
Fixed assets/non-current				6
Intangible assets:
Goodwill		N/A		249
Completed technology		3		11
Client relationships		3 – 5		13
Other		2 – 4		6
In-process research and development				—
Total assets acquired				365
Current liabilities				(85		)
Non-current liabilities				(30		)
Total liabilities assumed				(115		)
Total purchase price				$	251

 

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. None of the goodwill is deductible for tax purposes. The overall weighted-average life of the identified amortizable intangible assets acquired is 3.6 years. With the exception of goodwill, these identified intangible assets will be amortized on a straight-line basis over their useful lives. Goodwill of $249 million was  assigned to the Software ($185 million) and Global Technology Services ($64 million) segments.

9.               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).  See Note X, “Subsequent Events” in the company’s 2006 Annual Report.

The company initially created a wholly-owned subsidiary, InfoPrint Solutions (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.

The total consideration the company agreed to on January 24, 2007 (the date the definitive agreement was signed) was $725 million which was paid in cash to the company on the closing date.  The cash received was consideration for the initial 51 percent acquisition of InfoPrint by Ricoh as well as a prepayment for the remaining 49 percent to be acquired and certain royalties and services to be provided by the company to InfoPrint.  Final consideration for this transaction will be determined at the end of the three-year period based upon the participation in the profits and losses recorded by the equity partners. The company evaluated its ownership and participation in InfoPrint under the requirements of FIN 46(R), “Consolidation of Variable Interest Entities.” The company concluded that InfoPrint meets the requirements of a variable interest entity, the company is not the primary beneficiary of the entity and that deconsolidation of the applicable net assets was appropriate. The company’s investment in InfoPrint will be accounted for under the equity method of accounting.

The company will provide maintenance services for one year, certain hardware products for three years and other information technology and business process services to InfoPrint for up to five years.  The company assessed the fair value of these arrangements, and, as a result, has deferred $274 million of the proceeds.  This amount will be recorded as revenue, primarily in the company’s services segments, as services are provided to InfoPrint.  The deferred amount was recorded in Deferred income ($129 million current and $145 million non-current) in the Consolidated Statement of Financial Position.

The royalty agreements are related to the use of certain of the company’s trademarks for up to ten years.  The company assessed the fair value of these royalty agreements, and, as a result, has deferred $116 million of the proceeds.  This amount will be recognized as Intellectual property and custom development income as it is earned in subsequent periods.  The

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deferred amount was recorded in Deferred income ($41 million current and $75 million non-current) in the Consolidated Statement of Financial Position.

Net assets contributed, transaction related expenses and provisions were $90 million, resulting in an expected total pre-tax gain of $245 million, of which $81 million was recorded in Other (income) and expense in the Consolidated Statement of Earnings in the second quarter of 2007.

The deferred pre-tax gain of $164 million is primarily related to: (1) the transfer of the company’s remaining 49 percent interest in InfoPrint to Ricoh, and, (2) the transfer of certain maintenance services employees to InfoPrint.  The company will recognize this amount over a three year period as the remaining ownership interest is divested and the employees are transferred.  The pre-tax gain will be recorded in Other (income) and expense in the Consolidated Statement of Earnings.  At June 30, 2007, the deferred amount is recorded in Deferred income ($64 million current and $100 million non-current) in the Consolidated Statement of Financial Position.

10.   The changes in the goodwill balances, by reportable segment, for the six months ended June 30, 2007, are as follows:

Segment		Balance 12/31/06			Goodwill  Additions			Purchase  Price  Adjustments			Divestitures			Foreign  Currency  Translation  Adjustments			Balance  6/30/07
(Dollars in millions)
Global Technology Services		$	2,700		$	64		$	(7	)	$	—		$	5		$	2,762
Global Business Services		3,811			—			(5		)	—			128			3,934
Systems and Technology		214			—			—			—			—			214
Software		6,129			185			(27		)	—			5			6,292
Global Financing		—			—			—			—			—			—
Total		$	12,854		$	249		$	(39	)	$	—		$	138		$	13,201

 

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, 2007
Intangible asset class		Gross Carrying  Amount			Accumulated  Amortization			Net Carrying  Amount
(Dollars in millions)
Capitalized software		$	1,902		$	(826	)	$	1,076
Client-related		1,044			(497		)	548
Completed technology		477			(159		)	318
Strategic alliances		103			(98		)	5
Patents/Trademarks		117			(44		)	73
Other(a)		263			(193		)	69
Total		$	3,907		$	(1,817	)	$	2,090

 

		At December 31, 2006
Intangible asset class		Gross Carrying  Amount			Accumulated  Amortization			Net Carrying  Amount
(Dollars in millions)
Capitalized software		$	1,871		$	(837	)	$	1,034
Client-related		1,038			(424		)	614
Completed technology		500			(128		)	372
Strategic alliances		104			(89		)	15
Patents/Trademarks		112			(29		)	83
Other(a)		264			(179		)	84
Total		$	3,888		$	(1,686	)	$	2,202

 

(a)

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

 

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The net carrying amount of intangible assets decreased $112 million during the first six months of 2007 primarily due to the amortization of existing intangible asset balances, partially offset by net increases in software capitalization and acquired  intangible assets. The aggregate intangible asset amortization expense was $289 million and $580 million for the second quarter and first six months of 2007, respectively, versus $266 million and $531 million for the second quarter and first six months of 2006, respectively. In addition, in the first six months of 2006, the company retired $450 million of fully amortized intangible assets, impacting both the gross carrying amount and accumulated amortization by this amount.

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 June 30, 2007:

2007 (for Q3-Q4)		$	553 million
2008		$	791 million
2009		$	409 million
2010		$	173 million
2011		$	100 million

 

11.   The tables on pages 61 and 62 of this Form 10-Q reflect 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 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.

12.   The following table provides a rollforward of the current and non-current 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 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) the actions taken in 1999; and (6) actions that took place prior to 1994. See the company’s 2006 Annual Report, Note R on page 93 for additional information on the actions taken in 2005.

(Dollars in millions)		Liability  as of  12/31/2006			Payments			Other  adjustments*			Liability  as of  6/30/2007
Current:
Workforce		$	163		$	(81	)	$	38		$	120
Space		88			(28		)	24			84
Other		6			—			—			7
Total Current		$	257		$	(109	)	$	62		$	210
Non-current:
Workforce		$	531		$	—		$	(3	)	$	528
Space		109			—			(20		)	89
Total Non-current		$	640		$	—		$	(23	)	$	617

 

* The other adjustments column in the table above principally includes the reclassification of non-current to current and foreign currency translation adjustments. In addition, during the six-month period ended June 30, 2007, net adjustments were recorded to (1) increase  previously recorded liabilities for actions taken prior to 1994 ($5.3 million); (2) reduce previously recorded liabilities for actions taken in the second quarter of 2005 ($1.2 million), second quarter 2002 ($1.4 million) and fourth-quarter 2002 ($0.4 million). Of the net increase of $2.3 million, $3.2 million was included in Selling, General and Administrative expense and a $0.9 million reduction was recorded in Other (income) and expense. In addition, interest expense (accretion) of $14.8 million was recorded in Selling, General and Administrative expense and $2.0 million was recorded in Other (income) and expense.

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13.   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, benefits, securities, and environmental matters.  These actions may be commenced by a number of different constituents, 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 discussion 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. 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. A trial date has not been set.

In May 2005, the Louisiana Supreme Court denied the company’s motion to review and reverse a Louisiana state court’s certification of a nationwide class in a case filed against the company in 1995. The class consists of certain former employees who left the company in 1992, and their spouses, claiming damages based on the company’s termination of an education assistance program.  On July 3, 2007, the company and the plaintiffs filed a proposed class settlement agreement with the 19th Judicial District Court for the Parish of East Baton Rouge, Louisiana, where the legal action was filed.  On July 24, 2007, the Court gave its preliminary approval of the proposed settlement pursuant to which IBM would pay certain amounts to eligible individuals who took or would have taken an education course within a specified period after departing the company.  If the proposed settlement receives the final approval of the Court, IBM will also make contributions to support engineering education for women and minorities.  On October 1, 2007, the Court will hold a fairness hearing, at which the Court shall consider any objections to the proposed settlement and determine whether the proposed settlement shall be granted final approval.

On June 2, 2003, the company announced that it received notice of a formal, nonpublic investigation by the Securities and Exchange Commission (SEC), seeking information relating to revenue recognition in 2000 and 2001, primarily concerning certain types of client transactions. The company believes this investigation arose from a separate investigation by the SEC of Dollar General Corporation, a client of the company’s Retail Stores Solutions unit, which markets and sells point-of-sale products.  On January 8, 2004, the company announced that it received a “Wells Notice” from the staff of the SEC in connection with the staff’s investigation of Dollar General Corporation.  The separate SEC investigation noted above, relating to the recognition of revenue by the company in 2000 and 2001, was not the subject of this Wells Notice.

On June 25, 2007, the company announced that it reached an agreement with the SEC to settle all issues regarding the above-referenced investigations. IBM has consented, without admitting or denying any wrongdoing, to entry of an administrative order by the SEC directing that it cease and desist from committing or causing any violations of certain provisions of the federal securities laws and related SEC rules. In connection with the agreement, IBM paid an amount into a fund to be established in connection with the SEC’s action against Dollar General.  This payment was consistent with a provision previously established by the company. An IBM employee in the company’s Sales and Distribution unit also has resolved all issues with the SEC relating to the separate Wells Notice he received in connection with the staff’s investigation of Dollar General.

On June 27, 2005, the company announced that it had received a request to voluntarily comply with an informal investigation by the staff of the SEC concerning the company’s disclosures relating to the company’s first-quarter 2005 earnings and expensing of equity compensation. On January 12, 2006, the company announced that it received notice of a formal, nonpublic investigation by the SEC of this matter.  On June 5, 2007, the company announced that it reached an agreement with the SEC to settle this investigation.  In connection with the agreement, IBM has consented, without admitting or denying any wrongdoing, to entry of an administrative order by the SEC directing that IBM cease and desist from committing or causing any violations of certain of the reporting provisions of the federal securities laws and related SEC rules. The SEC’s order contains no finding of securities fraud or violation of any antifraud provision of the federal securities laws and related SEC rules. No monetary penalty or fine was imposed in connection with the resolution of this matter.

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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 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.

On January 24, 2006, a putative class action lawsuit was filed against IBM in federal court in San Francisco on behalf of technical support workers whose primary responsibilities are or were to install and maintain computer software and hardware. The complaint was subsequently amended on March 13, 2006. The First Amended Complaint, among other things, adds four additional named plaintiffs and modifies the definition of the workers purportedly included in the class. The suit, Rosenburg, et. al., v. IBM, alleges the company failed to pay overtime wages pursuant to the Fair Labor Standards Act and state law, and asserts violations of various state wage requirements, including recordkeeping and meal-break provisions. The suit also asserts certain violations of ERISA. Relief sought includes back wages, corresponding 401(k) and pension plan credits, interest and attorneys’ fees. On July 12, 2007, the District Court granted final approval to a class-wide settlement whereby IBM will pay $65 million plus certain interest for claims asserted by class members, plaintiffs’ attorneys’ fees and administrative costs. Individual payments will be based on factors, including the class member’s state of employment, time worked in the relevant job position and base salary. The charge associated with this settlement was consistent with a provision previously established by the company.

On October 23, 2006, the company filed two lawsuits against Amazon.com, Inc. (Amazon), in the United States District Court for the Eastern District of Texas, one in the Lufkin Division and one in the Tyler Division.  The Lufkin suit alleged that Amazon unlawfully infringed three IBM patents. The Tyler suit alleged that Amazon unlawfully infringed two IBM patents. The Lufkin Division patents cover methods for storing data, presenting applications and presenting advertising on a computer network. The Tyler Division patents cover an electronic catalog requisition system and related information retrieval and ordering methods and a computer-implemented hypertext system and method for operating a computer-implemented object-oriented hypertext system. Each suit sought, among other things, compensatory damages and injunctive relief. On December 14, 2006, Amazon answered, counterclaimed in each suit and sought to transfer the Lufkin suit to consolidate it with Tyler suit. IBM filed its opposition to the transfer motion on January 2, 2007 and answered the counterclaims in both suits on January 8. On January 16, 2007, the Lufkin court denied Amazon’s transfer motion.  In May 2007, the parties to the Lufkin suit and the Tyler suit settled these matters and both actions were dismissed.

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 asserted claims for patent infringement 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 January 19, 2007, PSI answered the 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. Discovery is proceeding and the court has ordered that the case be ready for trial in the Fall of 2008.

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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 ten 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 in connection with reductions in force. 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. IBM has moved to dismiss portions of the complaint; a decision is pending on that motion.

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 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. Similar to 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 $1.9 billion, including amounts currently in litigation and other amounts. 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 for the above items, including any changes to such liabilities for the quarter ended June 30, 2007, 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 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 company’s Consolidated Financial Statements; and the unique facts and circumstances of the particular matter which may give rise to additional factors.

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14.   The company’s extended lines of credit include unused amounts of $3,762 million and $2,895 million at June 30, 2007 and December 31, 2006, 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 $2,859 million and $2,496 million at June 30, 2007 and December 31, 2006, 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 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 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 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 $31 million and $32 million at June 30, 2007 and December 31, 2006, respectively.

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

(Dollars in millions)		2007			2006
Balance at January 1		$	582		$	754
Current period accruals		228			220
Accrual adjustments to reflect actual experience		(25		)	56
Charges incurred		(327		)	(386		)
Balance at June 30		$	458		$	645

 

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

15.   Subsequent Events: On July 16, 2007, the company announced an agreement to acquire DataMirror Corporation, a publicly held company, for approximately $160 million. This transaction is expected to close in the third quarter of 2007.

On July 31, 2007, the company announced that the Board of Directors approved a quarterly dividend of $0.40 per common share.  The dividend is payable September 10, 2007 to shareholders of record on August 10, 2007.

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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, 2007*

Snapshot

								Yr. To Yr.
								Percent/
(Dollars in millions except per share amounts)								Margin
Three months ended June 30:		2007			2006			Change
Revenue		$	23,772		$	21,890		8.6	%**
Gross profit margin		41.8		%	41.2		%	0.6	pts.
Total expense and other income		$	6,796		$	6,125		11.0	%
Total expense and other income to revenue ratio		28.6		%	28.0		%	0.6	pts.
Provision for income taxes		$	881		$	867		1.6	%
Income from continuing operations		$	2,261		$	2,022		11.8	%
Earnings per share from continuing operations:
Assuming dilution		$	1.55		$	1.30		19.2	%
Basic		$	1.57		$	1.31		19.8	%
Weighted average shares outstanding:
Assuming dilution		1,460.8			1,560.1			(6.4	)%
Basic		1,437.2			1,538.1			(6.6	)%

 

*		The following Results of Continuing Operations discussion does not include the hard disk drive (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. There was a $1 million loss from Discontinued Operations in the second quarter of 2007 and no loss for the first six months of 2007, versus no loss in the second quarter and first six months of 2006.
**		5.9 percent adjusted for currency

 

Within the Management Discussion, selected references to “adjusted  for currency” or “at constant currency” are made so that the financial results can be viewed without the impact of fluctuations in foreign currency exchange rates, thereby facilitating period-to-period comparisons of the company’s business performance.

In the second quarter, total revenue increased 8.6 percent as reported, 5.9 percent adjusted for currency, versus the second quarter of 2006. Pre-tax income from continuing operations was $3,142 million, up 8.8 percent compared to the prior year. Diluted earnings per share from continuing operations was $1.55 in the quarter and included a $0.05 gain from the divestiture of the company’s printing business in June; excluding the printer gain, diluted earnings per share increased 15.4 percent year- to-year. In the second quarter, the company executed a $12.5 billion accelerated share repurchase, and, in total, repurchased approximately nine percent of the common shares outstanding at March 31, 2007.

The company’s second quarter financial results demonstrated improving revenue growth, gross margin expansion and strong cash flow performance.

The revenue growth rate, adjusted for currency, at 5.9 percent, was the strongest quarterly growth rate in six years. Geographic results were strong; business performance was led by Asia Pacific which grew 9.8 percent (10 percent adjusted for currency). Europe continued to improve, up 13.5 percent (6 percent adjusted for currency). Americas had the best improvement versus the first quarter, led by the U.S. which grew 6 percent after a weak first-quarter 2007 performance. Improved sales execution and improving economic trends contributed to revenue results in the quarter. In addition, the company continued to benefit from its investments and strong growth in its emerging country markets where revenue grew 32.5 percent (25 percent adjusted for currency).

Segment revenue performance was driven by strong Software growth (12.7 percent), particularly in the key branded middleware offerings (22.8 percent), where over half of the growth was organic. In addition, both Global Services businesses had revenue growth of 10.1 percent in the second quarter. Systems and Technology revenue increased (1.8 percent) primarily driven by System x, System p and System z server revenue, and Systems Storage revenue, partially offset by a decline in Microelectronics and impacts from the divestiture of the printing business. Global Financing revenue increased (3.6 percent) reflecting an improvement in financing revenue due to an increase in financing assets and increased used equipment sales.

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The gross profit margin was 41.8 percent in the second quarter versus 41.2 percent in the second quarter of 2006.  The increase in the gross profit margin was primarily driven by operational efficiencies and a mix shift to higher margin businesses. Global Financing’s margin declined due to narrowing financing spreads and increased interest costs.

Total expense and other income increased over the year-earlier period by 11.0 percent.  The increase was primarily due to the company’s continuing investments in higher value capabilities, including middleware software, services, emerging countries and acquisitions. In addition, workforce rebalancing expenses increased, as well as interest expense driven by new debt related to the accelerated share repurchase, offset partially by the gain related to the sale of the printing business. The ratio of Total expense to revenue increased 0.6 points to 28.6 percent for the second quarter versus the comparable period of 2006.

The effective tax rate for the second quarter of 2007 was 28.0 percent versus 30.0 percent in the second quarter of 2006.

Cash flow from operating activities was $3,444 million, an increase of $877 million versus the second quarter of 2006 and an improvement of $428 million compared to the first quarter of 2007.

Total Global Services signings were $11.7 billion in the second quarter of 2007 as compared to $9.6 billion for the three months ended June 30, 2006.  The estimated total Global Services backlog was $116 billion at June 30, 2007, an increase of $1 billion versus March 31, 2007 and $7 billion versus June 30, 2006.

 

								Yr. To Yr.
								Percent/
(Dollars in millions except per share amounts)								Margin
Six months ended June 30:		2007			2006			Change
Revenue		$	45,801		$	42,549		7.6	%**
Gross profit margin		41.1		%	40.2		%	0.9	pts.
Total expense and other income		$	13,083		$	11,774		11.1	%
Total expense and other income to revenue ratio		28.6		%	27.7		%	0.9	pts.
Provision for income taxes		$	1,616		$	1,598		1.1	%
Income from continuing operations		$	4,105		$	3,730		10.1	%
Earnings per share from continuing operations:
Assuming dilution		$	2.75		$	2.37		16.0	%
Basic		$	2.80		$	2.40		16.7	%
Weighted average shares outstanding:
Assuming dilution		1,491.8			1,573.6			(5.2	)%
Basic		1,468.3			1,551.3			(5.4	)%

 

		6/30/07			12/31/06
Assets		$	102,548		$	103,234		(0.7	)%
Liabilities		$	85,792		$	74,728		14.8	%
Equity		$	16,756		$	28,506		(41.2	)%

 

**          4.8 percent adjusted for currency

 

For the first six months of 2007, total revenue increased 7.6 percent as reported, 4.8 percent adjusted for currency, versus the prior year. Pre-tax income from continuing operations was $5,721 million, a 7.4 percent increase compared to the first half of 2006. Diluted earnings per share from continuing operations was $2.75, reflecting a 16 percent improvement year-to-year.

Revenue performance in the first half was led by Software and both Global Services businesses. Geographically, Asia Pacific demonstrated the strongest business performance, with good improvement in Europe as well. Performance in the company’s emerging country markets remains very strong, with revenue growth of 28.4 percent (23 percent adjusted for currency) in the first half versus the first half of 2006.

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