How much of the reported revenue decline reflects underlying business weakness?

Very little. The 5.4% reported decline mostly reflects the April 2005 sale of the Personal Computing business, which contributed four months of 2005 revenue versus twelve months in 2004. Excluding PC revenue from both years, revenue grew 3.2% (2.8% at constant currency), led by Software, emerging-market growth of 23%, and strong pSeries, xSeries and Storage hardware demand. Japan and parts of Europe remained weak.

Are the 2005 earnings gains sustainable, given the one-time items?

Partly. Pre-tax income includes a $1.1B Lenovo gain and a $775M Microsoft settlement, while restructuring charges of about $1.7B were incurred in the second quarter. The net one-time effect is positive, so investors should look at operating trends. The filing points to continued Global Services margin improvement from restructuring and productivity actions, and management guides to double-digit EPS growth over the longer term, though pension expense is expected to rise $100-$200M in 2006.

How is IBM funding shareholder returns and how healthy is its balance sheet?

Operating cash flow of $14.9B covered $1.25B in dividends and $7.7B in gross buybacks, with the remainder funded by modest net debt issuance and cash from divestitures. Total debt was $22.6B, about flat year over year, and non-Global Financing debt rose to $2.1B mainly to fund the repatriation. Credit ratings (S&P A+, Moody's A1, Fitch AA-) were unchanged, and $5.0B remained authorized under the buyback program at year-end.

What are the most important legal and regulatory risks disclosed?

The main items are: (1) the Cooper v. IBM Personal Pension Plan age-discrimination case, where IBM could owe up to $1.4B more if it loses its appeal, with a ruling expected in 2006; (2) a formal SEC investigation (January 2006) into disclosures about Q1 2005 earnings and expensing of equity compensation, plus earlier SEC inquiries into 2000-2001 revenue recognition and the Dollar General matter; (3) an SCO Group copyright and Linux-related suit with trial scheduled for February 2007; and (4) a putative class action over technical support workers' overtime. Management states that the company does not expect material losses from these matters, though outcomes are inherently uncertain.

IBM 10-K FY2005 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed February 28, 2006. Cited figures are marked; the original filing is the authoritative source.

International Business Machines' FY2005 Form 10-K (filed February 28, 2006) shows a company that reshaped its portfolio while growing earnings.

Reported revenue fell 5.4% to $91.1 billion^a, but that decline was driven by the April 2005 sale of the Personal Computing business to Lenovo. Excluding PC revenue from both years, revenue rose 3.2% (2.8% in constant currency). Gross profit margin expanded 3.2 points to 40.1%, pre-tax income from continuing operations grew 14.6% to $12.2 billion, and diluted EPS from continuing operations rose 11.8% to $4.91.

Results were helped by a $1.1 billion^b Lenovo divestiture gain and a $775 million Microsoft antitrust settlement, partly offset by $1.7 billion of second-quarter restructuring charges. Cash generation was solid. Operating cash flow was $14.9 billion, and the company returned more than 100% of net income to shareholders through dividends ($1.25 billion) and buybacks ($7.7 billion gross).

Management repatriated $9.5 billion^c of foreign earnings under the American Jobs Creation Act, which raised the effective tax rate to 34.6% from 29.7%. Total debt was roughly flat at $22.6 billion, and the company's credit ratings were unchanged (S&P A+, Moody's A1). Global Services signings rose to $47.1 billion and backlog held at about $111 billion, while the Business Performance Transformation Services business grew 28%.

Risks flagged in the filing include a pending pension-related age discrimination case (up to $1.4 billion^d additional liability if IBM loses its appeal), an SEC investigation tied to a 2005 earnings disclosure and equity compensation expensing, and ongoing revenue weakness in Japan (down 13% as reported) and Hardware margin pressure in Storage. The company also said it expects double-digit EPS growth over the longer term, with Global Services and Software as its priority growth areas.

02—Key points

Key Highlights

Revenue fell 5.4% to $91.1B as reported, but rose 3.2% excluding the divested Personal Computing business.
Gross profit margin rose 3.2 points to 40.1%, driven largely by the PC divestiture and Global Services restructuring benefits.
Diluted EPS from continuing operations increased 11.8% to $4.91, with pre-tax income up 14.6% to $12.2B.
One-time items: $1.1B pre-tax gain on the Lenovo sale and $775M Microsoft settlement, offset by $1.7B of restructuring charges.
Operating cash flow of $14.9B; returned over 100% of net income via $7.7B of share repurchases and $1.25B of dividends.
Effective tax rate rose to 34.6% from 29.7% due to the one-time $525M repatriation charge on $9.5B of foreign earnings.
Legal and regulatory overhang: a pension age-discrimination case (up to $1.4B more if appeal fails) and a formal SEC investigation into equity compensation disclosures.

03—Questions

Frequently Asked Questions

How much of the reported revenue decline reflects underlying business weakness?
Very little. The 5.4% reported decline mostly reflects the April 2005 sale of the Personal Computing business, which contributed four months of 2005 revenue versus twelve months in 2004. Excluding PC revenue from both years, revenue grew 3.2% (2.8% at constant currency), led by Software, emerging-market growth of 23%, and strong pSeries, xSeries and Storage hardware demand. Japan and parts of Europe remained weak.
Are the 2005 earnings gains sustainable, given the one-time items?
Partly. Pre-tax income includes a $1.1B Lenovo gain and a $775M Microsoft settlement, while restructuring charges of about $1.7B were incurred in the second quarter. The net one-time effect is positive, so investors should look at operating trends. The filing points to continued Global Services margin improvement from restructuring and productivity actions, and management guides to double-digit EPS growth over the longer term, though pension expense is expected to rise $100-$200M in 2006.
How is IBM funding shareholder returns and how healthy is its balance sheet?
Operating cash flow of $14.9B covered $1.25B in dividends and $7.7B in gross buybacks, with the remainder funded by modest net debt issuance and cash from divestitures. Total debt was $22.6B, about flat year over year, and non-Global Financing debt rose to $2.1B mainly to fund the repatriation. Credit ratings (S&P A+, Moody's A1, Fitch AA-) were unchanged, and $5.0B remained authorized under the buyback program at year-end.
What are the most important legal and regulatory risks disclosed?
The main items are: (1) the Cooper v. IBM Personal Pension Plan age-discrimination case, where IBM could owe up to $1.4B more if it loses its appeal, with a ruling expected in 2006; (2) a formal SEC investigation (January 2006) into disclosures about Q1 2005 earnings and expensing of equity compensation, plus earlier SEC inquiries into 2000-2001 revenue recognition and the Dollar General matter; (3) an SCO Group copyright and Linux-related suit with trial scheduled for February 2007; and (4) a putative class action over technical support workers' overtime. Management states that the company does not expect material losses from these matters, though outcomes are inherently uncertain.

04—Continue

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