Snapshot



(Dollars in millions except per share amounts)



                                                                        Yr. To Yr.
                                                                         Percent/
                                                                          Margin
Three months ended September 30:                    2008       2007       Change
Revenue                                           $ 25,302   $ 24,119          4.9 %**
Gross profit margin                                   43.3 %     41.3 %        2.0 pts.
Total expense and other income                    $  7,064   $  6,676          5.8 %
Total expense and other income to revenue ratio       27.9 %     27.7 %        0.2 pts.
Provision for income taxes                        $  1,071   $    918         16.6 %
Income from continuing operations                 $  2,824   $  2,362         19.6 %
Net income                                        $  2,824   $  2,361         19.6 %
Net income margin                                     11.2 %      9.8 %        1.4 pts.
Earnings per share from continuing operations:
Assuming dilution                                 $   2.05   $   1.68         22.0 %
Basic                                             $   2.09   $   1.72         21.5 %
Weighted average shares outstanding:
Assuming dilution                                  1,379.1    1,405.8         (1.9 )%
Basic                                              1,350.7    1,371.4         (1.5 )%

** 1.7 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 third quarter, in a challenging economic environment, the company delivered solid financial results. Total revenue increased 4.9 percent as reported, 1.7 percent adjusted for currency, versus the third quarter of 2007. Pre-tax income from continuing operations was $3,895 million, up 18.7 percent compared to the prior year. Diluted earnings per share from continuing operations was $2.05, an increase of 22.0 percent year to year.

The company has been executing a strategy that has two major elements. In the emerging markets, the company continues to invest to capture opportunities created from the build out of the public and private infrastructures in these economies. In the more established markets, the company has been focused on driving productivity and improving efficiency while delivering transformational solutions that provide high value to its clients.

The company's focus on productivity has yielded a more efficient cost and expense structure. The company benefited from these structural changes in the third quarter delivering improved margins while revenue growth slowed in major markets.

In addition, the company's solid base of annuity businesses provide a good revenue foundation and a steady source of profit and cash. The company has built these businesses over many years and they provide the company with advantages in the current economic environment.

The company's balance sheet and liquidity positions remain strong. At September 30, 2008, cash on hand was approximately $10 billion; in addition, the company issued $4 billion in long-term debt on October 15, 2008 and continues to have access to a $10 billion global credit facility.

The company's third quarter financial results demonstrate that the combination of a solid annuity base, investments for growth in emerging markets, a continued focus on productivity, a range of products and services that deliver value to clients and a strong balance sheet and liquidity position enable the company to be well positioned in the current environment.

Total geographic revenue increased 6.0 percent (3 percent adjusted for currency) compared to the third quarter of 2007. Americas revenue increased 2.9 percent (2 percent adjusted for currency), Europe increased 10.1 percent (4 percent adjusted for currency) and Asia Pacific increased 5.8 percent (1 percent adjusted for currency). In the more established countries, which the company manages through its major markets organization, U.S. revenue growth was 1 percent and Canada increased 6 percent, adjusted for currency. In Europe, revenue adjusted for currency, increased 8 percent in Spain, 3 percent in the U.K. and 2 percent in Germany, France and Italy, respectively. Japan revenue, adjusted for currency, decreased 5 percent.

The company focuses on the emerging markets through its new growth markets organization. These countries represented 19 percent of the company's geographic revenue in the quarter and grew 12.7 percent (10 percent adjusted for currency). A subset of these countries, Brazil, Russia, India and China, together grew 18.7 percent (12 percent adjusted for currency). The increase was driven by double-digit growth in India of 23.7 percent (33 percent adjusted for currency), Brazil 27.9 percent (13 percent adjusted for currency) and Russia 51.4 percent (51 percent adjusted for currency).

On a segment basis, Software had the best revenue growth (11.8 percent), leveraging a strong annuity base and acquisitions. Global Technology Services revenue increased 8.5 percent, while Global Business Services revenue improved by 6.8 percent versus the third quarter of 2007, both driven by good short-term signings performance. Systems and Technology revenue decreased 9.5 percent, as this segment was most impacted by a slowdown in transactions at the end of the quarter. Total Systems revenue declined 6.5 percent in the third quarter, with growth in System z and converged System p partially offset by declines in System
x and legacy System i. Global Financing revenue increased 1.7 percent reflecting an improvement in financing revenue of 6.1 percent, offset by a decline in used equipment sales.

The gross profit margin was 43.3 percent, an increase of 2.0 points, primarily due to improved margins in Global Business Services (0.9 points of the increase), Global Technology Services (0.8 points of the increase) and improved segment revenue mix (0.4 points of the increase) driven by Software. These improvements were partially offset by a lower margin in Systems and Technology which impacted the overall margin by 0.4 points.

Total expense and other income increased 5.8 percent (2 percent adjusted for currency) for the third quarter of 2008 versus the third quarter of 2007. Overall, the increase was driven by approximately 4 points due to the effects of currency and 5 points due to acquisitions, with operational expense improving year to year.

The company's effective tax rate for the third quarter of 2008 was 27.5 percent versus 28.0 percent in the third quarter of 2007.

The company generated $3,738 million in cash flow provided by operating activities, a decrease of $746 million, compared to the third quarter of 2007, primarily driven by changes in operating assets and liabilities ($996 million), partially offset by increased net income ($462 million). Net cash used in investing activities of $1,496 million was $1,708 million lower than the third quarter of 2007, primarily due to net impact of purchases and sales of marketable securities and other investments ($1,002 million) and acquisitions ($351 million). Net cash used in financing activities of $1,881 million was $2,770 million higher, primarily due to increased common stock repurchases ($2,522 million) in the third quarter of 2008 versus the third quarter of 2007.

In the third-quarter 2008, total Global Services signings decreased 4 percent year to year to $12,675 million ($11,124 million adjusted for currency, down 5 percent). Short-term signings were $6,097 million, an increase of 13 percent year to year (8 percent adjusted for currency). Long-term signings were $6,578 million, a decrease of 16 percent (15 percent adjusted for currency). The estimated Global Services backlog, at constant currency, was $114 billion at September 30, 2008, down $2 billion versus the June 30, 2008 balance and down $2 billion versus the September 30, 2007 balance.

(Dollars in millions except per share amounts)

                                                                        Yr. To Yr.
                                                                         Percent/
                                                                          Margin
Nine months ended September 30:                     2008       2007       Change
Revenue                                           $ 76,623   $ 69,920          9.6 %**
Gross profit margin                                   42.7 %     41.1 %        1.6 pts.
Total expense and other income                    $ 21,818   $ 19,759         10.4 %
Total expense and other income to revenue ratio       28.5 %     28.3 %        0.2 pts.
Provision for income taxes                        $  2,999   $  2,534         18.4 %
Income from continuing operations                 $  7,907   $  6,467         22.3 %
Net income                                        $  7,907   $  6,466         22.3 %
Net income margin                                     10.3 %      9.2 %        1.1 pts.
Earnings per share from continuing operations:
Assuming dilution                                 $   5.68   $   4.42         28.5 %
Basic                                             $   5.79   $   4.50         28.7 %
Weighted average shares outstanding:
Assuming dilution                                  1,393.1    1,463.1         (4.8 )%
Basic                                              1,366.7    1,436.0         (4.8 )%




               9/30/08    12/31/07
Assets        $ 115,910   $ 120,431   (3.8 )%
Liabilities   $  88,391   $  91,962   (3.9 )%
Equity        $  27,519   $  28,470   (3.3 )%

For the first nine months of 2008, total revenue increased 9.6 percent as reported, 3.7 percent adjusted for currency, versus the prior year. Pre-tax income from continuing operations was $10,907 million, a 21.2 percent increase compared to the first nine months of 2007. Diluted earnings per share from continuing operations was $5.68, reflecting a 28.5 percent improvement year to year.

Americas revenue increased 6.5 percent (5 percent adjusted for currency), Europe increased 15.2 percent (5 percent adjusted for currency) and Asia Pacific increased 11.8 percent (3 percent adjusted for currency) in the first nine months of 2008. In the established countries, U.S. revenue growth was 4 percent and Canada increased 6 percent, adjusted for currency. In Europe, revenue adjusted for currency, increased 9 percent in Spain, 4 percent in the U.K., 3 percent in Italy, 2 percent in France and 2 percent in Germany. Japan revenue decreased 3 percent adjusted for currency year to year.

Across the geographies, aggregate revenue from the growth market countries increased 17.2 percent (12 percent adjusted for currency) in the first nine months of 2008 and represented approximately 18 percent of the company's geographic revenue. Revenue in the key growth countries of Brazil, Russia, India and China together grew 25.0 percent (15 percent adjusted for currency) in the first nine months of 2008 versus the first nine months of 2007.

The increase in year-to-date revenue was driven by double digit growth in the Global Services segments. Global Technology Services revenue increased 13.5 percent, while Global Business Services revenue improved by 13.8 percent. Software revenue increased 14.2 percent, led by branded middleware and contributions from acquisitions. Systems and Technology revenue decreased 4.5 percent primarily driven by weaker performance in Microelectronics OEM, legacy System i, System x and the impact of the prior year printer divestiture, partially offset by increased revenue for the new z10 mainframe and growth in converged System p servers and Storage. Total Systems revenue growth was 1.9 percent in the first nine months. Global Financing revenue increased 3.6 percent reflecting an improvement in financing revenue, offset by a decline in used equipment sales.

The gross profit margin was 42.7 percent, an increase of 1.6 points, primarily due to improved margins in Global Technology Services (0.8 points of the increase), improved segment revenue mix driven by Software (0.2 points of the increase), improved margins in Global Business Services (0.5 points of the increase) and improved margins in Systems and Technology (0.1 points of the increase).

Total expense and other income increased 10.4 percent (4 percent adjusted for currency) for the first nine months of 2008 versus the first nine months of 2007. Overall, the increase was driven by approximately 6 points due to the effects of currency and 5 points due to acquisitions, with operational expenses lower year-to-year.

The effective tax rate for the first nine months of 2008 was 27.5 percent versus 28.2 percent for the comparable period in 2007.

The company generated $12,191 million in cash flow provided by operating activities, an increase of $1,247 million, compared to the first nine months of 2007, primarily driven by increased net income ($1,440 million), partially offset by decreases in changes in operating assets and liabilities ($370 million). Net cash used in investing activities of $8,405 million was $2,632 million higher than the first nine months of 2007, primarily due to the Cognos and Telelogic acquisitions ($5,299) million, partially offset by the net impact of purchases and sales of marketable securities and other investments ($2,966 million). Net cash used in financing activities of $8,964 million was $4,845 million higher year to year, primarily due to net payments associated with debt ($13,267 million), partially offset by lower payments to repurchase common stock ($8,519 million).

Total assets decreased $4,521 million (decreased $1,723 million adjusted for currency) from December 31, 2007, primarily driven by lower cash and marketable securities ($6,391 million), lower financing receivables ($3,124 million), lower accounts receivable ($1,472 million) and lower investments and sundry assets ($1,235 million). These decreases were partially offset by increases in goodwill ($4,576 million) and intangible assets ($941 million) primarily due to the Cognos and Telelogic acquisitions, prepaid pension assets ($1,356 million) and prepaid expenses and other current assets ($823 million). The company had $9,755 million in cash and marketable securities at September 30, 2008.

Total liabilities decreased $3,570 million (decreased $2,509 million adjusted for currency) from December 31, 2007, primarily due to accounts payable ($1,285 million), taxes ($1,176 million), debt ($861 million), other accrued expenses and liabilities ($577 million) and deferred income ($427 million). These decreases were partially offset by an increase in other liabilities ($974 million).

Stockholders' equity of $27,519 million decreased $951 million from December 31, 2007, primarily due to increased treasury stock ($9,626 million) as a result of common stock repurchases, partially offset by higher retained earnings ($5,959 million) due to net income and common stock ($3,686 million) driven by stock option activity.

Third Quarter and First Nine Months in Review

Results of Continuing Operations

Segment Details

The following is an analysis of the third quarter and first nine months of 2008 versus the third quarter and first nine months of 2007 reportable segment external revenue and gross margin results.

(Dollars in millions)

                                                                          Yr. to Yr.
                                                                           Percent
                                                                            Change
                                                       Yr. to Yr.         Adjusting
For the three months ended                           Percent/Margin          for
September 30:                  2008        2007          Change            Currency
Revenue:
Global Technology Services   $  9,864    $  9,093               8.5 %            5.0 %
Gross margin                     32.7 %      30.6 %             2.1 pts.
Global Business Services        4,900       4,586               6.8 %            3.5 %
Gross margin                     27.4 %      22.9 %             4.5 pts.
Systems and Technology          4,431       4,898              (9.5 )%         (11.2 )%
Gross margin                     36.2 %      38.5 %            (2.4 )pts.
Software                        5,249       4,694              11.8 %            7.7 %
Gross margin                     84.7 %      84.2 %             0.5 pts.
Global Financing                  633         623               1.7 %           (1.2 )%
Gross margin                     49.1 %      44.6 %             4.5 pts.
Other                             224         225              (0.4 )%          (3.3 )%
Gross margin                     15.7 %       2.7 %            13.0 pts.
Total revenue                $ 25,302    $ 24,119               4.9 %            1.7 %
Gross profit                 $ 10,959    $  9,956              10.1 %
Gross margin                     43.3 %      41.3 %             2.0 pts.

(Dollars in millions)

                                                                          Yr. to Yr.
                                                                           Percent
                                                                            Change
                                                       Yr. to Yr.         Adjusting
For the nine months ended                            Percent/Margin          for
September 30:                  2008        2007          Change            Currency
Revenue:
Global Technology Services   $ 29,640    $ 26,106              13.5 %            7.1 %
Gross margin                     31.9 %      29.9 %             2.0 pts.
Global Business Services       14,918      13,108              13.8 %            7.1 %
Gross margin                     26.1 %      23.7 %             2.4 pts.
Systems and Technology         13,862      14,520              (4.5 )%          (8.3 )%
Gross margin                     37.3 %      36.9 %             0.4 pts.
Software                       15,670      13,723              14.2 %            7.9 %
Gross margin                     84.4 %      84.3 %             0.2 pts.
Global Financing                1,900       1,834               3.6 %           (1.6 )%
Gross margin                     51.8 %      47.2 %             4.6 pts.
Other                             633         630               0.6 %           (4.1 )%
Gross margin                      0.6 %      11.2 %           (10.6 )pts.
Total revenue                $ 76,623    $ 69,920               9.6 %            3.7 %
Gross profit                 $ 32,725    $ 28,760              13.8 %
Gross margin                     42.7 %      41.1 %             1.6 pts.

The following table presents each reportable segment's external revenue as a percentage of total external segment revenue.

                                      Three Months Ended        Nine Months Ended
                                        September 30,             September 30,
                                      2008         2007         2008         2007
Global Technology Services               39.3 %       38.1 %       39.0 %       37.7 %
Global Business Services                 19.5         19.2         19.6         18.9
Total Global Services                    58.9         57.2         58.6         56.6
Systems and Technology                   17.7         20.5         18.2         21.0
Global Financing                          2.5          2.6          2.5          2.6
Total Systems and
Technology/Global Financing              20.2         23.1         20.7         23.6
Software                                 20.9         19.6         20.6         19.8
Total                                   100.0 %      100.0 %      100.0 %      100.0 %

Global Services



(Dollars in millions)



                                                                 Yr. to Yr.
                                                                  Percent
For the three months ended September 30:     2008       2007       Change
Global Services Revenue:                   $ 14,764   $ 13,679          7.9 %
Global Technology Services                 $  9,864   $  9,093          8.5 %
Strategic Outsourcing                         5,084      4,729          7.5
Integrated Technology Services                2,329      2,096         11.1
Maintenance                                   1,815      1,712          6.0
Business Transformation Outsourcing             636        556         14.5
Global Business Services                   $  4,900   $  4,586          6.8 %

(Dollars in millions)

                                                                 Yr. to Yr.
                                                                  Percent
For the nine months ended September 30:      2008       2007       Change
Global Services Revenue:                   $ 44,559   $ 39,214         13.6 %
Global Technology Services                 $ 29,640   $ 26,106         13.5 %
Strategic Outsourcing                        15,278     13,632         12.1
Integrated Technology Services                6,894      6,054         13.9
Maintenance                                   5,515      4,859         13.5
Business Transformation Outsourcing           1,956      1,561         25.3
Global Business Services                   $ 14,918   $ 13,108         13.8 %

The company's Global Services segments, Global Technology Services and Global Business Services, had combined revenue of $14,764 million, an increase of 7.9 percent (4 percent adjusted for currency) in the third quarter and $44,559 million, an increase of 13.6 percent (7 percent adjusted for currency) in the first nine months of 2008, respectively, when compared to same periods of 2007. Revenue growth in the quarter continued to be driven primarily by short-term signings performance, but as expected, the rate of growth slowed compared to strong revenue growth in both segments in third-quarter 2007. In third-quarter 2008, total Global Services signings decreased 4 percent year to year to $12,675 million ($11,124 million adjusted for currency, down 5 percent). Short-term signings were $6,097 million, an increase of 13 percent year to year (8 percent adjusted for currency). Short-term signings increased in both the growth markets and the major markets with cost savings continuing to be the primary motivator. Long-term signings were $6,578 million, a decrease of 16 percent (15 percent adjusted for currency) compared to strong signings in the third quarter of 2007. Long-term signings declined in the major markets in the quarter, while long-term signings in the growth markets increased approximately 60 percent. The Global Services segments leveraged very strong margin performance and delivered combined pre-tax profit of $1,913 million in the third quarter and $5,111 million in the first nine months of 2008, an improvement of 23.5 percent and 28.6 percent, respectively, versus the same periods of 2007. The strong profit performance is a function of the quality of the segments contracts portfolio and ongoing programs to drive operational efficiencies and structural changes to the services cost base.

Global Technology Services (GTS) revenue increased 8.5 percent (5 percent adjusted for currency) and 13.5 percent (7 percent adjusted for currency) in the third quarter and first nine months of 2008, respectively, versus the third quarter and first nine months of 2007. Total signings in GTS decreased 8 percent (7 percent adjusted for currency) in the third quarter of 2008, with long-term signings decreasing 17 percent (14 percent adjusted for currency) and short-term signings increasing 19 percent (14 percent adjusted for currency).

Strategic Outsourcing (SO) revenue was up 7.5 percent (4 percent adjusted for currency) in the third quarter and 12.1 percent (5 percent adjusted for currency) in the first nine months of 2008, respectively, versus the same periods in 2007. Revenue increased 21 percent in the third quarter in the growth markets; however growth in the major markets moderated in the quarter due to a number of large contracts reaching a comparable year-over-year revenue basis and the impact of the lower level of long-term signings over the last few quarters. SO signings in the third quarter of 2008 decreased 19 percent (16 percent adjusted for currency) when compared to the third quarter of 2007.

Integrated Technology Services (ITS) revenue increased 11.1 percent (8 percent adjusted for currency) in the third quarter and 13.9 percent (8 percent adjusted for currency) in the first nine months of 2008 when compared to the same periods in 2007. Revenue growth continues to be driven by the key infrastructure offerings. ITS signings in the third quarter increased 19 percent (14 percent adjusted for currency) year to year. Signings were strong in the key infrastructure offerings and grew in all geographies and all sectors.

Maintenance revenue increased 6.0 percent (2 percent adjusted for currency) and 13.5 percent (7 percent adjusted for currency) in the third quarter and first nine months of 2008, respectively versus the same periods in the prior year. As expected, revenue growth moderated in the quarter due to the transfer of the Ricoh Infoprint maintenance contract.

Business Transformation Outsourcing (BTO) revenue increased 14.5 percent (15 percent adjusted for currency) in the third quarter and was up 25.3 percent (23 percent adjusted for currency) for the first nine months of 2008. BTO signings, which can vary significantly period-to-period, increased 14 percent (15 percent adjusted for currency) in the third quarter.

Global Business Services (GBS) revenue increased 6.8 percent (3 percent adjusted for currency) and 13.8 percent (7 percent adjusted for currency) in the third quarter and first nine months of 2008, respectively, versus the prior year periods. Revenue growth in the quarter was impacted by declines in two countries, Japan and Australia. When combined, these two countries were down 13 . . .