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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 


 

FORM 10-K

 

ANNUAL REPORT

Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

FOR THE YEAR ENDED DECEMBER 31, 2017

 

000-55786

(Commission file number)

 

IBM CREDIT LLC

(Exact name of registrant as specified in its charter)

 

Delaware

 

22-2351962

(State or Other Jurisdiction of
Incorporation or Organization)

 

(IRS employer identification number)

 

Armonk, New York

 

10504

(Address of principal executive offices)

 

(Zip Code)

 

914-765-1900

(Registrant’s telephone number)

 

Securities registered pursuant to Section 12(b) of the Act:

None

 

Securities registered pursuant to Section 12(g) of the Act:

Limited Liability Company Interests

(Title of class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act. Yes o  No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o  No x

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer o

Non-accelerated filer x

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

Emerging growth company o

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

 

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

 


 

REDUCED DISCLOSURE FORMAT

 

IBM Credit LLC (IBM Credit), an indirect, wholly owned subsidiary of International Business Machines Corporation, meets the requirements set forth in General Instruction I(1) of Form 10-K. In accordance with published guidance from the Securities and Exchange Commission’s Division of Corporation Finance, this Annual Report on Form 10-K omits certain disclosure items that correspond to the disclosure items that IBM Credit is permitted to omit from a Form 10-K pursuant to General Instruction I(2) of Form 10-K.

 


 

 

 



Table of Contents

 

Table of Contents

 

 

Page

 

 

PART I

 

 

 

Item 1. Business.

3

 

 

Item 1A. Risk Factors.

9

 

 

Item 1B. Unresolved Staff Comments.

13

 

 

Item 2. Properties.

13

 

 

Item 3. Legal Proceedings.

13

 

 

Item 4. Mine Safety Disclosures.

13

 

 

PART II

 

 

 

Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

14

 

 

Item 6. Selected Financial Data.

14

 

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

14

 

 

Item 7A. Quantitative and Qualitative Disclosures About Market Risk.

44

 

 

Item 8. Financial Statements and Supplementary Data.

46

Report of Independent Registered Public Accounting Firm

47

Consolidated Financial Statements

48

Notes to Consolidated Financial Statements

52

 

 

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.

86

 

 

Item 9A. Controls and Procedures.

86

 

 

Item 9B. Other Information.

86

 

 

PART III

 

 

 

Item 10. Directors, Executive Officers and Corporate Governance.

87

 

 

Item 11. Executive Compensation.

87

 

 

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

87

 

 

Item 13. Certain Relationships and Related Transactions, and Director Independence.

87

 

 

Item 14. Principal Accounting Fees and Services.

87

 

 

PART IV

 

 

 

Item 15. Exhibits, Financial Statement Schedules.

88

 

 

Item 16. Form 10-K Summary.

90

 

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Table of Contents

 

PART I

 

Item 1. Business.

 

Overview

 

IBM Credit LLC (IBM Credit or the company), a Delaware limited liability company, is an indirect, wholly owned subsidiary of International Business Machines Corporation (IBM). All of the limited liability company interests in IBM Credit LLC are owned by IBM GF International Holdings LLC, a Delaware limited liability company (the Member), which is also an indirect, wholly owned subsidiary of IBM. IBM Credit is engaged in providing financing solutions for information technology (IT) hardware, software and services.

 

IBM Credit was originally established as a subsidiary of IBM to provide financing solutions and remanufacturing and remarketing operations, in each case primarily for IBM products sold in the United States. Today, the company maintains a global organizational structure aligned with its operating segments, Client Financing and Commercial Financing. Client Financing primarily provides financing to end-user clients, which consist primarily of large, medium-sized and small corporations and other businesses, for their purchase of IBM products and services and original equipment manufacturers’ (OEM) IT products and services, in each case in order to finance clients’ total solution requirements. Client Financing also provides loans to IBM to finance the acquisition of IT assets used in client services contracts. The company believes the financing arrangements are predominantly for products and services that are critical to the end-user clients’ business operations. Commercial Financing provides working capital financing to suppliers, distributors, and resellers of IBM and OEM IT products and services. For information regarding the company’s operations by segment, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, and note M, “Segment Information,” to the Consolidated Financial Statements.

 

IBM Credit has the benefit of both deep knowledge of the company’s and IBM’s client base and insight into the hardware, software and services traditionally financed. These factors allow the company to effectively manage two of the major risks associated with financing: credit and residual value. These risks and others are discussed more fully in Item 1A, “Risk Factors.” The company also maintains long-term relationships with its clients through various stages of the IT asset life cycle — including initial purchase, technology upgrades and end-of-lease asset disposition.

 

Organizational Structure

 

IBM Credit was incorporated in Delaware in 1981 as IBM Credit Corporation and was subsequently converted to a limited liability company and renamed IBM Credit LLC in 2003.

 

IBM Credit operates as part of IBM’s Global Financing (IGF) business segment. The IGF business segment encompasses two primary activities: IBM Credit’s financing business and IBM’s remanufacturing and remarketing business. The remanufacturing and remarketing business includes sales, marketing and inventory management of used IBM and OEM IT products, and is conducted by IBM subsidiaries that are not part of IBM Credit.

 

In 2016, IGF established new entities to separate certain assets and liabilities related to IBM Credit’s financing business from IBM in the majority of countries where IGF operates. In most countries in which IBM Credit’s financing business was operated as a division of the IBM legal entity, a subsidiary was formed that acquired the assets and liabilities related to the financing business from the existing IBM legal entity. The remanufacturing and remarketing business and related assets and liabilities remained in the existing IBM legal entity. In the few countries where the financing business was not considered material to IBM Credit on a consolidated basis, such operations remained in the existing IBM legal entity. These countries’ operating results are not reported as part of IBM Credit. In countries in which the financing business already operated in a separate legal entity and included the remanufacturing and remarketing business, such legal entity was transferred to IBM Credit. In connection with each such transfer, the legal entity divested its assets and liabilities related to the remanufacturing and remarketing business to IBM prior to its transfer to IBM Credit. In 2017, IBM Credit directly or indirectly acquired all of the foreign legal entities that operate the financing business, as referenced above. This is intended to drive operational benefits by consolidating the financing business under IBM Credit.

 

The company divested its remanufacturing and remarketing business in the U.S. to IBM in 2016 to leverage IBM’s experience in product manufacturing, distribution, sales and service of IT equipment. The company concluded that the divestiture of the U.S. remanufacturing and remarketing business represented a significant strategic shift in the company’s operations which will have a material effect on its future financial results. As a result, the U.S. remanufacturing and remarketing business results are presented as discontinued operations for the historical periods included in the Consolidated Financial Statements. The foreign remanufacturing and remarketing business was divested by the foreign affiliates prior to

 

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Item 1. Business – (continued)

 

the company acquiring the foreign affiliates, and is therefore not included in the company’s Consolidated Financial Statements. For additional information, see note N, “Discontinued Operations,” to the Consolidated Financial Statements.

 

Business Segments

 

The company’s two operating segments, Client Financing and Commercial Financing, are business units that offer financing solutions based upon the needs of the company’s clients. The segments represent components of the company for which separate financial information is available and utilized on a regular basis by the chief operating decision maker in determining how to allocate resources and evaluate performance.

 

Each segment’s business and the financing solutions that generate the segment’s revenue, results of operations and asset portfolio are discussed further in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in note M, “Segment Information,” to the Consolidated Financial Statements.

 

Client Financing

 

The company provides leases and loan financing to end-user clients and acquires installment payment plans offered to end-user clients by IBM. End-user clients are primarily IBM clients who elect to finance their acquisition of IBM’s hardware, software, and services, as well as OEM IT hardware, software and services, to meet their total solution requirements. In addition, the company provides loans to IBM, primarily in support of IBM’s Technology Services & Cloud Platforms segment’s acquisition of IT assets, which are used in its external, revenue-producing services contracts.

 

Client Financing solutions are typically delivered as follows:

 

·                  Leases, Loans and Installment Payment Plans: Leases are primarily direct financing and operating leases for IBM’s hardware and select OEM IT hardware in areas in which IBM and the company have experience. Loans are primarily made to end-user clients to finance purchases of IBM and select OEM software and services, and are generally unsecured. These leases and loans are typically documented in contracts between IBM Credit and the end-user client.

 

In certain countries, the leases and loans are originated by IBM directly to the end-user client, and the company purchases the receivables and related equipment from IBM. In addition, IBM Credit supports IBM’s client offerings of installment payment plans for hardware, software and services to the end-user by purchasing receivables related to such payment plans from IBM. For additional information, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

·                  IBM Total Solution Offerings that include Financing: For certain IBM offerings, IBM Credit’s financing contract is bundled with IBM’s product and service contract to create a combined periodic payment schedule for the entire offering (Total Solution Offering). For Total Solution Offerings, the financing and non-financing amounts are provided in a single, combined periodic invoice for the IBM end-user client, such that each amount due to IBM Credit for the financing payment is collected by IBM along with the amounts due to IBM for the non-financing items. In these cases, IBM acts as IBM Credit’s billing and collection agent and forwards the financing payments to IBM Credit.

 

For IBM Total Solution Offerings in certain countries, as well as for certain government and other contracts, IBM Credit is not a party to IBM’s contract with the end-user client. Instead, IBM directly provides the end-user client with the financing. IBM Credit acquires a participation interest from IBM that represents the financing portion of such payments and assumes the associated credit risk of IBM’s end-user client from IBM. For additional information, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

·                  Other Financing to IBM: In certain countries, the company provides loans to IBM, primarily in support of IBM’s Technology Services & Cloud Platforms segment’s acquisition of IT assets which are used in its external, revenue-producing services contracts. The loan portfolio balance is renewed and repriced periodically with a net settlement for advances on new equipment acquisitions or repayments of principal on prior acquisitions.

 

Client Financing solutions are typically marketed and sold by IBM Credit employees, primarily in cooperation with IBM and business partner sales teams during the product and services sales cycle. Client Financing solutions are generally offered at

 

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Item 1. Business – (continued)

 

market rates that are competitive with what individual clients could obtain from other lenders. Client Financing solutions may also be offered at discounted rates, resulting from financing incentives provided by IBM, business partners or OEM IT providers through various financing incentive programs, allowing IBM Credit to realize a market yield. For additional information, see the “Financing Incentive Programs” section.

 

The company recovers the residual value of leased equipment by selling to IBM assets that have been returned from lease at cost, which approximates fair value. In addition, IBM may migrate a client to new technology. In the event this migration results in an early termination of a lease, IBM will purchase the returned equipment from the company at a pre-negotiated price, which is a function of the discounted value of the scheduled future lease payments and the residual value. The company may also obtain guarantees from financial institutions of the future value of the equipment to be returned at the end of lease. Guarantees may be obtained for both IBM and OEM IT products. For additional information on the residual value of leased assets and the sale of equipment returned from lease to IBM, see note A, “Significant Accounting Policies,” and note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

Commercial Financing

 

IBM Credit provides working capital financing to suppliers (consisting of IBM and suppliers of OEM IT products and services), distributors (typically third parties that purchase IT products from suppliers and provide those products to resellers) and resellers. This financing may take the form of loans to distributors and resellers, which are generally unsecured obligations of the client, but may be collateralized by inventory or accounts receivable. This financing may also include factoring, in which IBM Credit purchases receivables from suppliers, distributors or resellers.

 

IBM Credit generally extends payment terms in the range of 30 to 90 days to distributors and resellers in respect of their inventory purchases, while providing early settlement to suppliers at the supplier’s election. Suppliers generally provide financing incentives to reduce their distributors’ or resellers’ cost of financing for this term. The extended payment terms and early settlement provide liquidity to these clients. Commercial Financing is also important to suppliers and distributors because it enables them to shed credit risk, which is assumed by IBM Credit. For certain creditworthy distributors or resellers, IBM Credit may, at its discretion, allow a further extension of the repayment period for an additional financing charge. In addition, IBM Credit purchases interests in certain of IBM’s trade accounts receivable at a discount and assumes the credit risk of the IBM client.

 

Financial Regulation and Supervision

 

IBM Credit’s operations are subject to financial regulation within and outside the U.S., including licensing requirements and supervision. Although IBM Credit operates in all 50 states and in certain U.S. territories, the company is only required to be licensed for the type of financing it provides in a very limited number of states or territories. The company believes it is in material compliance with all licensing requirements in these states and territories. None of the company’s lender licenses are consumer finance licenses, as the company does not extend credit to consumers. In certain of these jurisdictions, as a result of being licensed as a non-bank lender, the company is or may be subject to compliance examinations, audits or information requests, including with respect to client complaints, by the relevant licensing agency. With respect to the type of commercial financing activities conducted by IBM Credit, state and local laws in the U.S. generally regulate debt collection practices and creditors’ rights, establish maximum interest rates and other charges and prohibit discrimination in the extension of credit and related activities.

 

In addition to state and local laws, IBM Credit is subject to certain federal financial laws and regulations, including, for example, the Equal Credit Opportunity Act which, among other things, prohibits discrimination in the extension of credit and related activities.

 

IBM Credit’s financing business outside the U.S. is generally conducted through subsidiaries and is subject to local financial laws and regulations, including, in certain jurisdictions, reporting requirements and the requirement to maintain an anti-money laundering program. A limited number of IBM Credit’s foreign subsidiaries are authorized or licensed as banks, credit institutions or non-bank lenders that are subject to heightened regulation, including, for example, capital requirements and prudential supervision by local authorities. The company’s regulated subsidiaries in these countries are subject to periodic examinations related to their financing business.

 

IBM Credit monitors its financing operations for compliance with applicable laws and regulations. The company believes it is in material compliance with all licensing requirements as are necessary to conduct its financing business both within and outside the United States and is in material compliance with all laws and regulations applicable to its financing operations.

 

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Item 1. Business – (continued)

 

Portfolio Risk Management

 

IBM Credit conducts a credit evaluation of its clients prior to extending financing. The credit evaluation takes into account current information about the client, such as published credit ratings, financial statements, news reports and current market implied credit analysis, as well as the current economic environment, outstanding obligations to the company and prior collection history. In some cases, commercial factors, including IBM’s relationship with a client, are also considered in making origination and other business decisions. Counterparty risks are managed at an overall IBM level and all subsidiaries, including IBM Credit, operate within those policies, principles and delegations. When appropriate, actions are taken to mitigate credit risk, such as requiring the inclusion of covenants from the client to protect against credit deterioration during the life of the obligation and obtaining credit enhancements, such as payment guarantees and letters of credit. The company performs additional credit evaluations of its clients on a regular basis. For additional information, see note E, “Financing Receivables, Receivables Purchased/Participated from IBM,” to the Consolidated Financial Statements.

 

IBM Credit employs a rigorous process to optimize portfolio risk and to obtain additional credit capacity in support of new business opportunities. IBM Credit engages in portfolio risk mitigation by entering into various non-recourse and limited recourse agreements with third parties consisting primarily of domestic and foreign financial institutions including banks, commercial and vendor finance companies, equipment lessors, credit insurers and other specialty finance companies. Third party arrangements may be funded or unfunded and include participations, sales and assignments, factoring, credit insurance, and other credit risk mitigation structures under discretionary or committed facilities. In limited instances, the company sells financing receivables and operating leases (and related assets) to third parties.

 

Financing Incentive Programs

 

IBM and OEM IT suppliers from time to time sponsor financing incentive programs that allow the company to offer waived or reduced rate financing for marketing program offerings and sales promotions. Pursuant to these programs, IBM or OEM IT suppliers offer a discount to IBM Credit that enables the company to realize a market yield on any financing contract entered into either directly or indirectly under these incentive programs. Market yield is based on the credit quality of the client and the length of the contract.

 

The volume of financing incentive programs sponsored by IBM and others, and the split of those programs between leases and loans, may vary over time depending upon the marketing strategies of the respective supplier.

 

Client Services

 

Once a financing arrangement is in place, the company provides its clients with timely direct settlement of financial obligations with such clients’ suppliers. The company provides account management and client service and support throughout the financing relationship. This includes reminders for payment, processing of payments and handling of client billing questions. The company provides end-of-lease options, including purchase, extension or return of leased equipment.

 

Relationship with IBM

 

IBM Credit is a captive finance company and an indirect, wholly owned subsidiary of IBM. IBM Credit generally conducts its financing activities with IBM on an arm’s-length basis, subject in certain cases, particularly with respect to originations, to commercial factors, including IBM’s relationship with a client. The following is a description of certain material relationships between IBM and IBM Credit regarding support, borrowing, licensing, service and other arrangements. For additional information, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

IBM Support Agreement

 

IBM Credit and IBM are parties to a support agreement, which became effective on May 2, 2017 (the Support Agreement). Pursuant to the Support Agreement, IBM has agreed with IBM Credit that IBM will:

 

·                  retain, directly or indirectly, beneficial ownership of at least 51 percent of the equity voting interests in IBM Credit at all times;

·                  cause IBM Credit to, on the last day of each of IBM Credit’s fiscal years, have a consolidated tangible net worth of at least $50 million (with consolidated tangible net worth for purposes of this discussion of the Support Agreement

 

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Item 1. Business – (continued)

 

understood to mean (a) the total assets of IBM Credit and its subsidiary companies less (b) the intangible assets and total liabilities of IBM Credit and its subsidiary companies); and

·                  cause the leverage ratio of IBM Credit to be no more than 11 to 1 for each of IBM Credit’s fiscal quarters (with leverage ratio for purposes of this discussion of the Support Agreement understood to mean, for any calendar quarter, IBM Credit’s debt-to-equity ratio as reported in, and calculated in the manner set forth in, IBM Credit’s periodic report covering such fiscal quarter).

 

In the event that IBM Credit’s leverage ratio as of the end of any fiscal quarter is higher than 11 to 1, then, upon demand by IBM Credit, IBM has agreed to make or cause to be made a capital contribution to IBM Credit in an amount sufficient to cause the leverage ratio to not exceed 11 to 1.

 

The Support Agreement is not a guarantee by IBM of any indebtedness, other obligation, or liability of any kind of IBM Credit.

 

IBM or IBM Credit may each terminate the Support Agreement upon giving the other party 30 days prior written notice, with a copy of such notice to each rating agency that is then rating any outstanding debt (with debt for purposes of this discussion defined as IBM Credit’s indebtedness for borrowed money that either (i) is rated by one or more rating agencies or (ii) is designated by the board of managers of IBM Credit as constituting debt for purposes of the Support Agreement). The Support Agreement may be modified or amended only by the written agreement of IBM and IBM Credit and upon 30 days prior written notice to each rating agency rating any outstanding debt. However, such termination, modification or amendment will not be effective with respect to any debt outstanding at the time of such termination, modification or amendment unless (a) such termination, modification or amendment is permitted under the documentation governing such debt, (b) all affected holders of such debt (or, in the case of debt incurred pursuant to documentation that permits the Support Agreement to be terminated, modified, or amended with the consent of less than all of the holders of such debt, the requisite holders of such debt) otherwise consent in writing or (c) with respect to debt that is rated by one or more rating agencies at the request of IBM or IBM Credit, each such rating agency confirms in writing that the rating assigned to such debt by such rating agency will not be withdrawn or reduced because of the proposed action.

 

Under the terms of the Support Agreement, the Support Agreement is not enforceable against IBM by anyone other than (a) IBM Credit or (b) if any case is commenced under the United States Bankruptcy Code (11 U.S.C. §§ 101 et seq.), or any successor statutory provisions (the Bankruptcy Code), in respect of IBM Credit, the debtor in possession or trustee appointed by the court having jurisdiction over such proceeding. In the event of (1) a breach by IBM in performing a provision of the Support Agreement and (2) the commencement of such a case under the Bankruptcy Code with respect to IBM Credit while any debt is outstanding, the remedies of a holder of debt shall include the right, if no proceeding on behalf of IBM Credit has already been commenced in such case, to file a petition in respect of IBM Credit thereunder with a view to the debtor in possession, or the trustee appointed by the court having jurisdiction over such proceeding, pursuing IBM Credit’s rights under the Support Agreement.

 

The Support Agreement is governed by and construed in accordance with the laws of the State of New York.

 

Borrowing Relationship

 

The company has a credit facility with IBM that allows the company to obtain short-term and long-term funding on an as needed basis and the company seeks to substantially match fund the term, currency and interest rate variability of its debt against its underlying financing assets. The general terms of the loans are set forth in a customary intercompany loan agreement, which includes standard default clauses (including failure to pay interest or principal when due, bankruptcy and ceasing to be a wholly owned subsidiary). The specific terms of any individual loan, including the interest rate and term applicable to each loan, are set forth in a loan confirmation statement that is issued at the time of each individual borrowing under the facility. IBM Credit is entitled to prepay loans issued under this credit facility from time to time, subject to payment of any agreed penalty or premium. Loans with IBM under such agreements are included in the Consolidated Statement of Financial Position as debt payable to IBM. Interest expense incurred on these borrowings from IBM is included in financing cost in the Consolidated Statement of Earnings. For additional information on short-term and long-term funding, see note G, “Borrowings,” to the Consolidated Financial Statements.

 

Services and Other Arrangements

 

The company sources a number of services from IBM, including functional support for collection administration, treasury, accounting, legal, tax, human resources, marketing and IT services. The company also has the right to use certain IBM intangibles in its business. Where practical, allocations of the expenses incurred by IBM in the provision of these functional

 

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Item 1. Business – (continued)

 

support services are based upon direct usage. For the remainder, where possible, expenses are allocated on measurable non-financial drivers, such as number of employees. When a clear and measurable non-financial driver cannot be established, these expenses are allocated based on a measurable financial driver, such as net margin. Management believes that these allocation methods are reasonable. In addition, the company conducts its global operations primarily from IBM leased or IBM owned facilities for which IBM charges the company for occupancy expenses based on square footage space usage with no fixed term commitment. For additional information regarding the historical allocation of expenses by IBM to the company, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

The company participates in the various IBM stock-based compensation plans, including awards of Restricted Stock Units and Performance Share Units. For additional information, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

The company participates in certain multiemployer retirement-related plans that are sponsored by IBM. Charges from IBM to the company in relation to these multiemployer plans (including non-pension, post-retirement benefits) are limited to service costs. The company is charged by IBM using an allocation method based on the number of employees. Contributions and any other type of costs for these multiemployer plans are the responsibility of IBM. In certain countries, the retirement-related plan obligation is owned by the company and is generally calculated using actuarial valuations. These plans are accounted for as multiple-employer plans. Under these plans, IBM manages the assets and allocates them to the company based on the company’s obligation. For additional information, see note L, “Retirement-Related Benefits,” to the Consolidated Financial Statements.

 

Expenses related to the services discussed above are included in Selling, General and Administrative (SG&A) expense in the Consolidated Statement of Earnings. It is not practical to estimate the actual costs that would have been incurred had IBM Credit been a separate company during the periods presented. These costs may not be indicative of the expenses that IBM Credit will incur in the future or would have incurred if the company had obtained these services from a third party.

 

The company also invests a portion of its excess cash in short-term interest bearing accounts with IBM, which can be withdrawn upon demand. For additional information, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

Tax Sharing Agreement

 

The company’s U.S. federal and certain state and foreign operations are included in various IBM consolidated tax returns; and in such cases, IBM makes payments to tax authorities on the company’s behalf. IBM and the company maintain a Tax Sharing Agreement for any operations included in an IBM consolidated tax return pursuant to which IBM charges the company for any taxes owed and reimburses the company for tax attributes generated. Such charges or reimbursements are based upon a calculation of the company’s relevant pro forma stand-alone tax return. For additional information, see note K, “Taxes,” to the Consolidated Financial Statements.

 

Competition

 

The company operates in a highly competitive environment, where financing for users of IBM hardware, software and services and OEM IT products and services is available through a variety of sources. The company’s strong relationship with IBM provides the company with access to capital and the ability to manage increased exposures, each of which generates a competitive advantage. The key competitive factors in Client Financing and Commercial Financing include interest rates charged, IT product experience, client service, contract flexibility, ease of doing business, global capabilities and residual values. In providing financing solutions to clients, the company competes with three types of companies: other captive financing entities of IT companies, non-captive financing entities and banks and financial institutions.

 

Geographic Results

 

The company reports revenue on a geographic basis within Item 7, “Management Discussion and Analysis of Financial Condition and Results of Operations.” The geographies include the Americas, Europe/Middle East/Africa (EMEA), and Asia Pacific. The company also provides information regarding total revenue and earning assets in the U.S. and foreign countries in note M, “Segment Information,” to the Consolidated Financial Statements.

 

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Item 1. Business – (continued)

 

Forward-looking and Cautionary Statements

 

Certain statements contained in this Annual Report on Form 10-K may constitute “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995 (“Reform Act”). Forward-looking statements are based on the company’s current assumptions regarding future business and financial performance. These statements by their nature address matters that are uncertain to different degrees. The company may also make forward-looking statements in other reports filed with the Securities and Exchange Commission and in materials delivered to lenders and in press releases. In addition, the company’s and IBM representatives may from time to time make oral forward-looking statements. Forward-looking statements provide current expectations of future events based on certain assumptions and include any statement that does not directly relate to any historical or current fact. Words such as “anticipates,” “believes,” “expects,” “estimates,” “intends,” “plans,” “projects” and similar expressions, may identify such forward-looking statements. Any forward-looking statement in this Form 10-K speaks only as of the date on which it is made. The company assumes no obligation to update or revise any forward-looking statements. In accordance with the Reform Act, set forth under Item 1A, “Risk Factors” in this Form 10-K are cautionary statements that accompany those forward-looking statements. Readers should carefully review such cautionary statements as they identify certain important factors that could cause actual results to differ materially from those in the forward-looking statements and from historical trends. Those cautionary statements are not exclusive and are in addition to other factors discussed elsewhere in this Form 10-K, in the company’s filings with the Securities and Exchange Commission or in materials incorporated therein by reference.

 

Item 1A. Risk Factors.

 

The Company’s Financial Condition is in Large Part Dependent upon IBM: A significant portion of IBM Credit’s financing business consists of financing associated with the sale of IBM’s products and services. Financing originations, which determine the company’s financing asset base, are impacted by IBM’s product and services sales volumes and IBM Credit’s participation rates in those sales. Participation rates reflect the propensity of IBM’s clients to finance their transactions through IBM Credit in lieu of paying IBM up-front cash or financing through a third party. As discussed above under “Financing Incentive Programs,” IBM Credit participates in certain marketing programs in conjunction with IBM that allow the company to offer financing to end-user clients, which provides IBM Credit with a competitive advantage in financing IBM’s offerings. Any change in these marketing programs, IBM’s distribution methods or reduction in the company’s ability to offer competitively priced financing to IBM end-user clients could reduce the company’s participation rates in IBM’s product and service offerings, which could have a material adverse effect on the business, financial condition, results of operations and cash flows of the company. IBM also provides IBM Credit with other types of operational and administrative support, which are integral to the conduct of the company’s business. For additional information, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements. Any changes in the levels of support from IBM could also negatively impact the company’s results. Further, if there were significant changes in IBM’s liquidity or capital position, the quality of IBM’s offerings, transfers of ownership of IBM’s products or services, or other factors, impacting IBM or its products, such changes could significantly affect IBM Credit’s financial condition and results of operations. In addition, IBM has one of the strongest brand names in the world, and its brand and overall reputation could be negatively impacted by many factors, including if IBM does not continue to be recognized for its industry-leading technology and solutions. If negative perceptions tarnish IBM’s or IBM Credit’s brand image and reputation, IBM Credit’s ability to attract and retain clients could be impacted. The success of IBM’s business and operations and demand for IBM products and services are subject to a number of risks, including, among others:

 

·                  IBM’s ability to reach its growth and productivity objectives under its long-term business strategy;

 

·                  IBM’s ability to continue its cutting-edge innovation and ability to commercialize such innovations;

 

·                  Risks from IBM’s investments in strategic growth imperatives to drive revenue growth and market share;

 

·                  IBM’s relationship with its critical suppliers;

 

·                  Quality issues with IBM products;

 

·                  IBM’s reliance on third party distribution channels and ecosystems; and

 

·                  Risks from IBM’s acquisitions, alliances and dispositions, including integration challenges.

 

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Item 1A. Risk Factors – (continued)

 

Additionally, the company’s credit ratings depend, in part, on the existence of the Support Agreement with IBM. If this arrangement, or replacement arrangements, if any, are modified, or if a credit rating of IBM is lowered, the company’s credit ratings could be negatively impacted, potentially leading to higher borrowing costs and negatively impacting the company’s ability to offer competitively priced financing to its clients, which could have a material adverse effect on the business, financial condition, results of operations and cash flows of the company.

 

Downturn in Economic Environment Could Impact the Company’s Business: If there is a downturn in the economic environment, generally or specific to certain industries in which IBM Credit’s clients operate, clients may be unable to meet their debt obligations and they may not enter into new financing arrangements, which could negatively impact the company’s financial results.

 

Technology Sector Innovation Initiatives Could Impact Client’s Propensity to Enter into Financing Arrangements: As IBM and other suppliers of technology transform their offerings and enter new market segments, some new offerings and delivery models may be less conducive to traditional financing than the historical offerings. While the company makes efforts to adapt IBM Credit’s financing business and offerings to these changes, the company may not be successful and this could have negative impacts on the company’s financial results and long-term success.

 

The Company’s Reliance on Partner Relationships Could Impact its Business: The company offers its solutions directly and through a variety of business partners, including suppliers, distributors and resellers of IT hardware, software and services. Changes in the business condition, financial or otherwise, of these parties could negatively impact the company and affect its ability to bring its solutions to market. If the company moves into new areas, partners may be unable to keep up with changes in IBM Credit’s offerings, and the company may be unable to recruit and enable appropriate partners. In addition, the failure of partners to comply with all applicable laws and regulations may prevent the company from working with them, which could negatively impact the company and affect its ability to bring solutions to market.

 

The Company’s Financial Performance Could be Impacted by its Ability to Collect Receivables in a Timely Manner and Result in Sustaining Potential Unexpected Credit Losses: Changes in the concentration of credit and the credit risk of IBM Credit’s clients can be impacted by global, country, industry and client specific economic conditions, which in turn may impact the clients’ working capital and their ability to make scheduled payments on the company’s financing receivables. In addition, client allegations and disputes regarding product quality, service delivery concerns, amounts due to the company under Total Solution Offerings or other circumstances unique to the clients, may cause them to delay scheduled payments when due. IBM Credit’s ability to collect receivables and generate sufficient cash to meet its business obligations, including servicing its debt, can have a significant impact on the company’s business operations.

 

Additionally, the company’s client base includes a variety of enterprises, from small and medium businesses to the world’s largest organizations and governmental entities. The company performs ongoing credit evaluations of its clients’ financial conditions. These credit evaluations rely in part on third party information, including information provided by the company’s clients, and may not successfully detect and prevent fraud or misconduct by the company’s end-user clients or other third parties. Any such fraud or misconduct could have a significant impact on the company’s ability to collect receivables. If the company becomes aware of information related to the creditworthiness of a client, or, if actual default rates on receivables in the future differ from those currently anticipated, the company may have to adjust its allowance for credit losses, which could affect the company’s financial position and results of operations.

 

Changes to Residual Value Could Adversely Affect the Profitability of the Company’s Lease Transactions: The recorded residual values of lease assets are estimated at the inception of the lease to be the expected fair value of the assets at the end of the lease term. The estimated residual value of leased equipment is based on a number of factors, including, historical market sales prices, past remarketing experience, any known significant market or product trends and IBM’s remarketing plans. If residual values significantly decline or if residual values are incorrectly estimated, in each case due to economic factors, product quality issues, market or client behavior changes, fraud or misconduct by end-user clients or other third parties, unforeseen technology innovations or any other circumstances, it may lower financing margin and income or result in losses.

 

The Company’s Financial Performance Could be Impacted by Exposure to Currency and Financing Risks and Changes in Market Liquidity Conditions: The company derives a significant percentage of its revenues and costs from its operations in local currency environments, which are affected by changes in the relative values of the U.S. dollar and foreign currencies. Further, inherent in the company’s business are risks related to the interest rate and currency fluctuations on the associated debt and liabilities. Changes in interest rates or changes in the global economy (including currency fluctuations) could have a negative impact on both revenue and net margin. Although the company seeks to substantially match fund the term, currency and interest rate variability of its debt against its underlying financing assets, risks may arise from a mismatch between assets

 

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Item 1A. Risk Factors – (continued)

 

and the related liabilities used for funding. The company employs several strategies to manage these risks, including the use of derivative financial instruments. However, there can be no assurance that the company’s efforts to manage its currency and financing risks will be successful. The company’s financial performance is exposed to a wide variety of industry sector dynamics worldwide that could impact IBM Credit’s ability to generate sufficient cash to service its debt. The company’s earnings and cash flows, as well as its access to funding, could be negatively impacted by changes in market liquidity conditions. For more information about the company’s liquidity position, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” in this Form 10-K.

 

IBM Credit’s ability to make payments on, or to refinance, its indebtedness and to fund the company’s operations depends on its ability to generate cash and its ability to access the capital markets. These factors, to a certain extent, are subject to general economic, financial, competitive, legislative, regulatory, capital market and other conditions that are beyond the company’s control. The availability and cost of financing is also influenced by the company’s credit ratings, which depend in part on the existence of the Support Agreement with IBM. If IBM Credit is unable to generate sufficient cash flows in the future to service its debt, the company may be required to refinance all or a portion of its existing debt or to obtain additional financing. There can be no assurance that any refinancing will be available or that additional financing could be obtained on acceptable terms. In the absence of other funding alternatives, a protracted period where the company could not access the capital markets would likely lead to a slowdown in originations. The inability to service or refinance the company’s existing debt, which has a dependency on IBM, or to obtain additional financing could have a material adverse effect on the financial position, liquidity, and results of operations of the company.

 

Certain of the Company’s Operations Are Subject to Financial Regulation, Supervision and Licensing under Various Laws and Regulations: The company is required to comply with a range of financial laws and regulations within and outside the U.S., which may be costly to adhere to and may affect both the results of its operations and its ability to service its earning assets. Compliance with these laws and regulations requires that the company maintain certain licenses and be subject to examinations or audits by supervisory authorities in certain jurisdictions in which it operates. Failure to comply with such laws and regulations in any particular jurisdiction could result in significant civil penalties and other sanctions, such as a revocation of the company’s license to do business in that jurisdiction. In the event the company were to become subject to any such sanctions, its business in the affected jurisdiction could be adversely affected, which in turn could have a material adverse effect on IBM Credit’s business prospects, results of operations or financial condition.

 

Due to the Company’s Global Presence, its Business and Operations Could be impacted by Local Legal, Economic, Political and Health Conditions: The company is a global business, so changes in the laws or policies of the countries in which the company operates, or inadequate enforcement of laws or policies, could affect the company’s business and overall results of operations. Substantial revisions that U.S. and foreign governments are undertaking or considering in areas such as the regulation and supervision of financial institutions, including financing and leasing companies, may have an effect on the company’s structure, operations, sales, liquidity, capital requirements, effective tax rate and performance. The company’s results of operations could also be affected by economic and political changes around the world and by macroeconomic changes, including recessions, inflation, currency fluctuations between the U.S. dollar and foreign currencies and adverse changes in trade relationships between countries. Further, as the company expands its client base and the scope of its offerings, both within the U.S. and globally, the company may be impacted by additional regulatory or other risks, including compliance with U.S. and foreign financial industry laws and regulations, data privacy requirements, anti-money laundering laws, tax laws, anti-competition regulations, anti-corruption laws, import and trade restrictions and export requirements. In addition, any widespread outbreak of an illness, pandemic or other local or global health issue or uncertain political climates, international hostilities, natural disasters, or any terrorist activities, could negatively affect client demand and the company’s operations.

 

Cybersecurity and Privacy Considerations Could Impact the Company’s Business: In the current environment, there are numerous and evolving risks to cybersecurity and privacy, including criminal hackers, hacktivists, state-sponsored intrusions, industrial espionage, employee malfeasance and human or technological error. Computer hackers and others routinely attempt to breach the security of technology systems, and to fraudulently induce employees, clients and others to disclose information or unwittingly provide access to systems or data. The risk of such attacks to the company includes attempted breaches not only of its own systems, but also those of its clients, contractors, business partners, vendors and other third parties. The systems utilized by the company involve the storage, processing and transmission of sensitive data, including proprietary or confidential data, regulated data, and personal information of employees, clients and others. Successful breaches, employee malfeasance, or human or technological error could result in, for example, unauthorized access to, disclosure, modification, misuse, loss, or destruction of company, client, or other third party data or systems; theft of sensitive, regulated, or confidential data including personal information and intellectual property; the loss of access to critical data or systems through ransomware, destructive attacks or other means; and business delays, service or system disruptions or denial of service. In the event of such actions, the company, its clients, and other third parties could be exposed to potential

 

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Item 1A. Risk Factors – (continued)

 

liability, litigation, and regulatory or other government action, as well as the loss of existing or potential clients, damage to brand and reputation, and other financial loss. In addition, the cost and operational consequences of responding to breaches and implementing remediation measures could be significant.

 

The global regulatory environment with regard to cybersecurity, privacy and data protection issues, including the General Data Protection Regulation coming into force in the European Union in May 2018, is increasingly challenging and may have impacts on the company’s business, including increased costs and expanded compliance obligations. IBM Credit has the ability to leverage IBM’s leading security technologies and solutions, as well as regulatory compliance practices, but as the cybersecurity and corresponding regulatory landscape evolves, the company could incur additional cost, or may also find it necessary to make further significant investments in the future to protect data and infrastructure. Cybersecurity risk to the company and its clients will also depend on factors, such as actions, practices and investments of clients, contractors, business partners, vendors and other third parties.

 

The Company is Subject to Legal Proceedings and Investigatory Risks: As a global company with business operations, employees and clients in many countries, the company is or may be involved, either as a plaintiff or defendant or other party, in a variety of ongoing claims, demands, suits, investigations, tax matters and proceedings that arise from time to time in the ordinary course of its business. The company believes that it has adopted appropriate risk management and compliance programs. Legal and compliance risks, however, will continue to exist and additional legal proceedings and other contingencies, the outcome of which cannot be predicted with certainty, may arise from time to time. Additional information on legal matters is included in note J, “Contingencies and Commitments,” to the Consolidated Financial Statements.

 

Tax Matters could impact the Company’s Results of Operations and Financial Condition: The company is subject to income taxes in both the U.S. and numerous foreign jurisdictions. The company’s provision for income taxes and cash tax liability in the future could be negatively affected by numerous factors including, but not limited to, income before taxes being lower than anticipated in countries with lower statutory tax rates and higher than anticipated in countries with higher statutory tax rates, changes in the valuation of deferred tax assets and liabilities, and changes in tax laws, regulations, accounting principles or interpretations thereof, which could negatively impact the company’s results of operations and financial condition in future periods. The Organization for Economic Cooperation and Development (OECD) is issuing guidelines that are different, in some respects, than long-standing international tax principles. As countries unilaterally amend their tax laws to adopt certain parts of the OECD guidelines, this may increase tax uncertainty and may negatively impact the company’s income taxes. Local country, state, provincial or municipal taxation may also be subject to review and potential override by regional, federal, national or similar forms of government.

 

The company’s U.S. federal and certain state and foreign operations are included in various IBM consolidated tax returns and therefore are not directly subject to corporate income taxes but instead settle their tax liabilities with IBM. Any subsequent tax assessments or benefits resulting from tax examinations are the responsibility of IBM. For separate income tax return filings for jurisdictions that are not included in IBM’s tax return, the company is subject to the continuous examination of such income tax returns by tax authorities in those jurisdictions. The company regularly assesses the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of its provision for income taxes. There can be no assurance that the outcomes from these continuous examinations will not have an adverse effect on the company’s provision for income taxes and cash tax liability.

 

The Company Could be Impacted by its Business with Government Clients: The company’s clients include numerous governmental entities and clients whose primary customers are government-owned entities. Some of the company’s agreements with these clients may be subject to periodic funding approval. Funding reductions or delays could negatively impact public sector demand for IBM’s products and services, and therefore, demand for the company’s financing offerings could be negatively impacted. Also, some agreements may contain provisions allowing the client to terminate without cause or may provide for higher liability limits for certain losses. In addition, the company could be suspended or debarred as a governmental contractor and could incur civil and criminal fines and penalties, which could negatively impact the company’s results of operations and financial results.

 

The Company’s Use of Accounting Estimates Involves Judgment and Could Impact the Company’s Financial Results: The application of generally accepted accounting principles requires the company to make estimates and assumptions about certain items and future events that directly affect the company’s reported financial condition. In addition, adopting new accounting standards can also pose challenges to the company. The company’s most critical accounting estimates including the methods used by management to estimate the amount of uncollectible receivables are described in note A, “Significant Accounting Policies,” to the Consolidated Financial Statements. In addition, as discussed in note J, “Contingencies and Commitments,” to the Consolidated Financial Statements, the company makes certain estimates including decisions related to

 

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Item 1A. Risk Factors – (continued)

 

legal proceedings and reserves. These estimates and assumptions involve the use of judgment. As a result, actual financial results may differ.

 

Ineffective Internal Controls Could Impact the Company’s Business and Operating Results: The company’s internal controls over financial reporting may not prevent or detect misstatements because of its inherent limitations, including the possibility of human error, the circumvention or overriding of controls, or fraud. Even effective internal controls can provide only reasonable assurance with respect to the preparation and fair presentation of the financial statements. If the company fails to maintain the adequacy of its internal controls, including any failure to implement required new or improved controls, or if the company experiences difficulties in its implementation, the company’s business and operating results could be harmed and the company could fail to meet its financial reporting obligations.

 

Risks Related to the Company’s Securities: The company issues debt securities in the capital markets from time to time, with a variety of different maturities. The value of the company’s debt securities fluctuates based on many factors, including the methods employed for calculating principal and interest, the maturity of the securities, the aggregate principal amount of securities outstanding, the redemption features for the securities, the level, direction and volatility of interest rates, changes in exchange rates, exchange controls, governmental regulations and other factors over which the company has little or no control. The company’s ability to pay interest and repay the principal for its debt securities is dependent upon its ability to manage its business operations, as well as the other risks described under this Item 1A, “Risk Factors.” There can be no assurance that the company will be able to manage any of these risks successfully. In addition, changes by any rating agency to the company’s outlook or credit ratings can negatively impact the value and liquidity of the company’s debt securities. The company does not make a market in its debt securities and cannot provide any assurances with respect to the liquidity or value of such securities. Further, a secondary market may never develop or be maintained for any series of the debt securities. If a secondary market does develop, it may not continue or it may not be sufficiently liquid to allow bondholders to resell debt securities if or when desired or at a price that bondholders consider acceptable.

 

Item 1B. Unresolved Staff Comments.

 

Not applicable.

 

Item 2. Properties.

 

IBM Credit’s principal executive offices are located in an office building owned by IBM in Armonk, New York. The company is globally located and conducts its business primarily from IBM leased or IBM owned facilities around the world. IBM charges the company for the use of these facilities. For additional information regarding the company’s shared facilities, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

Item 3. Legal Proceedings.

 

See note J, “Contingencies and Commitments,” to the Consolidated Financial Statements.

 

Item 4. Mine Safety Disclosures.

 

Not applicable.

 

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PART II

 

Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

 

IBM Credit is a Delaware limited liability company and an indirect, wholly owned subsidiary of IBM. At December 31, 2017, all limited liability company interests in IBM Credit were owned by the Member, which is also an indirect, wholly owned subsidiary of IBM. The company has no other class of equity securities issued and outstanding. Dividends are declared and paid by IBM Credit as determined by its Board of Managers. The company paid $531 million in cash distributions to IBM during 2017, of which $94 million was distributed in the first quarter, prior to the company converting to the consolidated basis of reporting, and is recorded in net transfers to IBM in the Consolidated Statement of Cash Flows and Consolidated Statement of Member’s Interest.

 

Item 6. Selected Financial Data.

 

IBM Credit has omitted this section pursuant to General Instruction I(2)(a) of Form 10-K.

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The “Management Discussion and Analysis of Results of Operations and Financial Condition” (Management Discussion and Analysis) is designed to provide readers with an overview of the business and a narrative on the company’s financial results and certain factors that may affect its future prospects from the perspective of the company’s management. The Management Discussion and Analysis presents an overview of the key performance drivers in 2017.

 

The Management Discussion and Analysis contains the results of operations for each reportable segment of the business and a discussion of the company’s financial position and cash flows. The summary of key financial information presented within the Management Discussion and Analysis should be read in conjunction with the Consolidated Financial Statements, and with Item 1A, “Risk Factors,” and “Forward-Looking and Cautionary Statements” included below. Other key sections within the Management Discussion and Analysis include: “Liquidity and Capital Resources” and “Looking Forward”.

 

Overview

 

IBM Credit generates revenue from the financing activities of its two operating segments, Client Financing and Commercial Financing.

 

The Client Financing segment generates revenue by providing financing to end-user clients and IBM, as well as purchasing installment payment plans, leases, loans and participated receivables from IBM.

 

Lease and loan contracts between IBM Credit and end-user clients are included in the Consolidated Statement of Financial Position as net financing receivables or equipment under operating leases, and the revenue is included as financing revenue or operating lease revenue in the Consolidated Statement of Earnings.

 

In certain countries, IBM originates leases, loans and installment payment plans with its end-user clients and IBM Credit acquires the related receivables (and related assets for leases) at a discounted purchase price under certain financing incentive programs. IBM Credit accounts for the acquisition of these receivables as a purchase of receivables in accordance with accounting guidance. These receivables are included within net financing receivables in the Consolidated Statement of Financial Position. Income is recognized by the company over the term of the financing, and the income is recorded as financing revenue in the Consolidated Statement of Earnings.

 

For IBM Total Solution Offerings in certain countries, as well as for certain government and other contracts, IBM Credit is not a party to IBM’s contract with the end-user client. Instead, IBM directly provides the end-user client with the lease, loan or installment payment plan. Beginning in 2016, IBM Credit acquired a participation interest in IBM receivables that represents the financing portion of such transactions and assumes the associated credit risk of the IBM end-user client from IBM. These participation interests are included in the Consolidated Statement of Financial Position as receivables purchased/participated from IBM and the financing income earned from these receivables is included in financing revenue in

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

the Consolidated Statement of Earnings. Prior to 2016, these receivables were part of the financing receivables in the Consolidated Statement of Financial Position.

 

In certain countries, the company provides loans to IBM primarily in support of its Technology Services & Cloud Platforms segment’s acquisition of IT assets used in external, revenue-producing client services contracts. This financing is included in the Consolidated Statement of Financial Position as financing receivables from IBM. The financing income earned from these receivables is included in financing revenue in the Consolidated Statement of Earnings.

 

Starting in 2016, with the formation of the new financing subsidiaries, the company sells to IBM equipment returned from lease at cost, which approximates fair value. In addition, IBM may migrate a client to new technology. In the event this migration results in an early termination of a lease, IBM will purchase the returned equipment from the company at a pre-negotiated price, which is a function of the discounted value of the scheduled future lease payments and the residual value. Net gains on these transactions are recorded within the Client Financing segment as other (income) and expense in the Consolidated Statement of Earnings.

 

The Commercial Financing segment provides working capital financing to suppliers, distributors and resellers of IT products and services where the company generally extends payment terms in the range of 30 to 90 days. A portion of the interest cost may include financing incentives from IBM or providers of OEM IT products and services to cover an interest-free period. Financing may take the form of loans to distributors and resellers, which are generally unsecured obligations of the clients, but may be collateralized by inventory or accounts receivable. Commercial Financing also includes factoring, in which IBM Credit purchases the receivable from suppliers, distributors or resellers. These financing transactions are included in the Consolidated Statement of Financial Position as net financing receivables and the financing income is included in financing revenue in the Consolidated Statement of Earnings. Income earned from financing incentives related to Commercial Financing is included in financing revenue and is recognized over the term of the financing.

 

The company also purchases interests in certain of IBM’s trade accounts receivable at a discount and assumes the credit risk of IBM’s clients. These transactions are included in receivables purchased/participated from IBM in the Consolidated Statement of Financial Position and the financing income is included in financing revenue in the Consolidated Statement of Earnings. The discount is recognized as financing revenue over the term of the financing.

 

The segments include an allocation of interest expense and SG&A expense by the company to each of its operating segments. Interest expense is allocated based on average assets in each segment. SG&A expense is allocated based on a measurable financial driver, such as net margin.

 

Key drivers of the company’s financial results are the overall health of the economy, its impact on corporate IT budgets, interest rates and originations. Financing originations, which determine the asset base of the annuity-like business, are also dependent upon the demand for IT products and services, IBM’s product cycles and services offerings, as well as client participation rates. Participation rates reflect the propensity of clients to finance their transaction through the company in lieu of paying the supplier up-front with cash or financing through a third party. The economy can also impact the credit quality of the company’s receivables portfolio and therefore the level of provision for credit losses. Interest rates and the overall economy (including currency fluctuations) can affect both revenue and net margin. Interest rates directly impact the company by increasing or decreasing financing revenue and associated borrowing costs.

 

On December 31, 2016, the company divested the assets and liabilities of its U.S. remanufacturing and remarketing business to IBM. The operating results of this business are reported as discontinued operations in the Consolidated Financial Statements for 2016. For additional information, see note N, “Discontinued Operations,” to the Consolidated Financial Statements.

 

On December 22, 2017, the Tax Cuts and Jobs Act (“U.S. tax reform”) was enacted in the U.S. This Act resulted in the company recognizing a fourth quarter provisional one-time net tax benefit of $162 million. For additional information, see note K, “Taxes,” to the Consolidated Financial Statements.

 

Within the Management Discussion and Analysis, certain columns and rows and other figures may not add due to the use of rounded numbers for disclosure purposes. Percentages reported are calculated from the underlying whole-dollar numbers.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Year in Review

 

The following section provides a summary of the company’s consolidated financial results for 2017 as compared to 2016:

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the year ended December 31:

 

2017

 

2016

 

Change

 

Revenue

 

$

1,702

 

$

1,840

 

(7.5

)%

Net margin

 

$

1,109

 

$

1,170

 

(5.2

)%

Net margin percentage

 

65.2

%

63.6

%

1.6

pts.

Total expense and other (income)

 

$

354

 

$

450

 

(21.4

)%

Income from continuing operations before income taxes

 

$

755

 

$

719

 

4.9

%

Provision for income taxes 1

 

$

5

 

$

222

 

(97.8

)%

Income from continuing operations 1

 

$

750

 

$

498

 

50.7

%

Income from continuing operations margin 1

 

44.1

%

27.0

%

17.0

pts.

Income from discontinued operations, net of tax

 

$

 

$

131

 

NM

 

Net income 1

 

$

750

 

$

629

 

19.3

%

 


(1)         The enactment of U.S. tax reform resulted in the company recognizing a provisional net benefit of $162 million in December 2017. The net benefit was primarily the result of the re-measurement of deferred tax balances to the new U.S. federal tax rate as well as the U.S. transition tax and any foreign tax costs on undistributed foreign earnings. As a result, Net Income, Return on Equity and Member’s Interest increased and Debt-to-Equity was reduced in the fourth quarter and for the full-year 2017.

NM - Not meaningful

 

 

 

 

 

 

 

Yr.-to-Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

At December 31:

 

2017

 

2016

 

Change

 

Total Assets

 

$

39,516

 

$

35,279

 

12.0

%

Total Liabilities

 

$

35,954

 

$

31,577

 

13.9

%

Total Member’s Interest

 

$

3,562

 

$

3,703

 

(3.8

)%

 

At December 31:

 

2017

 

2016

 

Debt-to-Equity Ratio *

 

8.6

x

7.3

x

 


* The debt-to-equity ratio is calculated by dividing the total amount of debt outstanding by the total amount of Member’s interest in the company at the end of the reporting period presented.

 

Return on Equity

 

(Dollars in millions)

 

 

 

 

 

At December 31:

 

2017

 

2016

 

After tax income from continuing operations (1)

 

$

750

 

$

498

 

Average equity * (2)

 

$

3,375

 

$

3,639

 

Return on equity (1)/(2)

 

22.2

%

13.7

%

 


* Average of the ending balance of Member’s interest for the last five quarters on a continuing operations basis.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Financial Performance Summary for 2017 and 2016:

 

In 2017, the company delivered revenue of $1,702 million and net income of $750 million. In 2016, the company had revenue of $1,840 million, income from continuing operations of $498 million and income from discontinued operations, net of tax, of $131 million, resulting in net income of $629 million. In 2017, return on equity was 22.2 percent as compared to 13.7 percent in the prior year.

 

Total revenue decreased $139 million, or 7.5 percent, in 2017 as compared to 2016, driven by a decrease in operating lease revenue of $104 million, or 21.5 percent, and a decrease in financing revenue of $35 million, or 2.6 percent. The decrease in operating lease revenue was mainly due to a decline in average assets during 2017 as a result of a decrease in originations and asset sales to third parties. The decrease in financing revenue was due to a decline in yields on financing receivables, partially offset by an increase in average assets. Yields from any category of assets are the company’s rate of return on such assets and are calculated by dividing income from such assets by average assets during the period.

 

From a segment perspective, Client Financing revenue of $1,248 million in 2017 declined 14.2 percent as compared to 2016. The decline was driven by a decrease in lease and loan average asset balances and yields, and a decline in operating leases. Commercial Financing revenue of $454 million in 2017 increased 17.7 percent as compared to 2016. The increase in revenue was driven by an increase in average assets, partially offset by a decline in yields.

 

From a geographic perspective, revenue in 2017 declined across each of the geographies as compared to 2016. Americas revenue of $938 million declined 7.1 percent in 2017 as compared to 2016. EMEA revenue of $467 million declined 4.2 percent in 2017 as compared to the prior year. Asia Pacific revenue of $297 million declined 13.5 percent in 2017 as compared to 2016.

 

Net margin, which is calculated as revenue less financing costs and depreciation of equipment under operating lease was $1,109 million in 2017. Net margin decreased $61 million, or 5.2 percent, in 2017 as compared to 2016, driven by the decrease in revenue noted above, partially offset by a decrease in depreciation expense and financing cost. Depreciation expense decreased $76 million, or 24.7 percent, in 2017 as compared to 2016, primarily due to declines in operating lease average assets in 2017 as compared to the prior year. The decrease in financing cost in 2017 was due to declining average interest rates as a result of geographical mix of the asset portfolio, partially offset by an increase in average borrowings as compared to 2016. Net margin percentage of 65.2 percent in 2017 increased by 1.6 points compared to the prior year.

 

Total expense and other (income) of $354 million decreased $96 million, or 21.4 percent, in 2017 compared to $450 million in 2016. The year to year decrease in expense and other (income) was driven by a decrease in provisions for credit losses; an increase in other (income) and expense primarily from the sale of equipment upon early lease termination as a result of client migrations to IBM’s z14 mainframe which became available late in the third quarter of 2017; and a reduction in SG&A.

 

Pre-tax income from continuing operations of $755 million in 2017 increased 4.9 percent as compared to the prior year. The increase in pre-tax income was driven by the decline in total expense and other (income), partially offset by the decline in net margin noted above. Pre-tax income from continuing operations margin percentage of 44.3 percent in 2017 increased on a year-to-year basis by 5.3 points.

 

The provision for income taxes decreased $217 million in 2017 compared to 2016 primarily due to the enactment of U.S. tax reform resulting in a provisional net benefit of $162 million in the fourth quarter of 2017. The net benefit was primarily the result of the re-measurement of deferred tax balances to the new U.S. federal tax rate as well as the U.S. transition tax and any foreign tax costs on undistributed foreign earnings. For additional information, see note K, “Taxes,” to the Consolidated Financial Statements.

 

Income from continuing operations increased $252 million, or 50.7 percent, in 2017 as compared to 2016. Income from continuing operations margin of 44.1 percent in 2017 increased 17.0 points year to year. The continuing operations effective tax rate was 0.6 percent in 2017 as compared to 30.8 percent in 2016, driven primarily by the one-time benefit from the enactment of U.S. tax reform and a more favorable geographic mix of earnings.

 

Net income increased $121 million in 2017 on a year-to-year basis. The increase was primarily driven by the decrease in the provision for income taxes due to the one-time benefit from the enactment of U.S. tax reform and the increase in other (income) and expense year to year, partially offset by the decline in financing margins and the decrease in net income from discontinued operations of $131 million related to the company’s divestiture of its U.S. remanufacturing and remarketing business to IBM in 2016. For additional information, see note N, “Discontinued Operations,” to the Consolidated Financial

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Statements. Return on equity from continuing operations in 2017 increased by 8.5 points driven primarily by the increase in net income and a lower average equity balance year to year.

 

At December 31, 2017, the company continued to have the financial flexibility to support the business over the long term. Total assets of $39,516 million increased $4,237 million from December 31, 2016 driven by an increase in total financing receivables (which includes financing receivables, financing receivables from IBM and receivables purchased/participated from IBM) of $2,956 million and an increase in cash and cash equivalents of $908 million. Total liabilities of $35,954 million increased $4,378 million from December 31, 2016 driven by increases in debt of $3,447 million and accounts payable of $1,029 million. Member’s interest of $3,562 million decreased $141 million from December 31, 2016.

 

The company’s debt-to-equity ratio increased to 8.6 to 1 at December 31, 2017 as compared to the debt-to-equity ratio of 7.3 to 1 at December 31, 2016. Total Member’s interest decreased 3.8 percent to $3,562 million, while debt of $30,477 million increased $3,447 million, or 12.8 percent, in support of the company’s target debt-to-equity ratio of 9 to 1.

 

The company generated $1,034 million in cash flow from operating activities in 2017, an increase of $25 million as compared to the prior year, driven by a reduction in cash tax payments and a decrease in interest payments on debt. Net cash used in investing activities of $1,482 million in 2017 was $2,433 million higher when compared to net cash provided in 2016 of $951 million, primarily driven by an increase in financing receivable originations and lower collections year to year. Net cash provided by financing activities of $1,308 million increased $2,949 million when compared to the prior year use of cash of $1,641 million. The increased source of cash was driven primarily by higher net debt issuances and lower net distributions to IBM.

 

Business Segments and Capabilities

 

IBM Credit and its subsidiary companies are reported by the company’s parent, IBM, as part of IBM’s Global Financing segment, which also includes IBM’s remanufacturing and remarketing business. The company’s operating segments, Client Financing and Commercial Financing, are business units that offer financing solutions based upon the needs of the company’s clients. Client Financing provides leases and loan financing to end-user clients and acquires installment payment plans offered to end-user clients by IBM; as well as acquires participation interests in IBM financing receivables for which the company assumes the IBM client’s credit risk from IBM. End-user clients are primarily IBM clients that elect to finance their acquisition of IBM’s hardware, software, and services, as well as OEM IT hardware, software and services, to meet their total solution requirements. In addition, the company provides loans to IBM, primarily in support of IBM’s Technology Services & Cloud Platforms segment’s acquisition of IT assets, which are used in its external, revenue-producing services contracts. Commercial Financing provides working capital financing for suppliers, distributors and resellers of IBM and OEM IT products and services. Commercial Financing also purchases interests in certain of IBM’s trade accounts receivable at a discount and assumes the credit risk of IBM’s client. The Client Financing and Commercial Financing business segments are described in more detail in Item 1, “Business.”

 

Results of Continuing Operations

 

Segment Details

 

The following is an analysis of the 2017 reportable segment results as compared to 2016. The table below presents each reportable segment’s revenue and net margin results. Segment pre-tax income is the income from continuing operations before income taxes and excludes income from discontinued operations.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/
Margin

 

For the year ended December 31:

 

2017

 

2016

 

Change

 

Client Financing

 

 

 

 

 

 

 

Revenue

 

$

1,248

 

$

1,455

 

(14.2

)%

Net margin

 

771

 

887

 

(13.1

)%

Net margin percentage

 

61.8

%

60.9

%

0.8

pts.

Pre-tax income

 

$

574

 

$

564

 

1.8

%

Pre-tax margin

 

46.0

%

38.8

%

7.2

pts.

Commercial Financing

 

 

 

 

 

 

 

Revenue

 

$

454

 

$

385

 

17.7

%

Net margin

 

338

 

283

 

19.3

%

Net margin percentage

 

74.5

%

73.5

%

1.0

pts.

Pre-tax income

 

$

181

 

$

155

 

16.3

%

Pre-tax margin

 

39.8

%

40.3

%

(0.5

)pts.

Total Segments

 

 

 

 

 

 

 

Revenue

 

$

1,702

 

$

1,840

 

(7.5

)%

Net margin

 

1,109

 

1,170

 

(5.2

)%

Net margin percentage

 

65.2

%

63.6

%

1.6

pts.

Pre-tax income

 

$

755

 

$

719

 

4.9

%

Pre-tax margin

 

44.3

%

39.1

%

5.3

pts.

 

Client Financing

 

Client Financing revenue of $1,248 million in 2017 decreased by $207 million, or 14.2 percent, as compared to 2016. The decrease in financing revenue was driven by a decline in average assets and a decline in yields from leases and loans. The decline in yields was mainly driven by declining average interest rates in 2017 due to the geographical mix of assets, predominately due to lower asset balances in Brazil. An increase in financing revenue from financing receivables from IBM and financing receivables participated from IBM partially offset these declines. Operating lease revenue declined $104 million, mainly due to a decline in average assets during 2017 as a result of a decrease in originations and asset sales to third parties.

 

Net margin decreased $116 million, or 13.1 percent, as compared to 2016. The decrease was driven by the revenue decline noted above, partially offset by a decrease in depreciation of $76 million and a decrease in interest expense of $15 million. The decrease in depreciation was due to the decline in average assets during the year as noted above, and the decrease in interest expense was due to lower average debt in higher interest rate countries during 2017.

 

Pre-tax income increased $10 million, or 1.8 percent, in 2017 as compared to 2016. The increase was primarily driven by an increase in equipment sales to IBM of $80 million and a decline in the provision for credit losses of $43 million, partially offset by a decline in net margin of $116 million. The increase in equipment sales to IBM was driven by a higher level of early lease terminations as a result of client migration to IBM’s z14 mainframe. The decline in the provision for credit losses in 2017 was primarily due to lower specific reserve requirements in Latin America. At December 31, 2017, the allowance for credit losses coverage was 0.9 percent, a decrease of 41 basis points as compared to December 31, 2016.

 

Commercial Financing

 

Commercial Financing revenue of $454 million in 2017 increased $68 million, or 17.7 percent, as compared to 2016. The growth in revenue was driven by an increase in average financing receivable assets due to increased volumes primarily with existing OEM IT suppliers, partially offset by a decline in yields from these investments during the year due to competitive market conditions and lower interest rates in 2017.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Net margin increased $55 million, or 19.3 percent, as compared to 2016. The increase was driven by an increase in revenue as noted above, partially offset by an increase in interest expense of $14 million. The increase in interest expense was due to higher average asset balances in 2017.

 

Pre-tax income increased $25 million, or 16.3 percent, as compared to 2016 driven primarily by the increase in net margin noted above, partially offset by an increase in SG&A expense of $21 million.

 

Geographic Revenue

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent

 

For the year ended December 31:

 

2017

 

2016

 

Change

 

Revenue

 

$

1,702

 

$

1,840

 

(7.5

)%

Geographies

 

 

 

 

 

 

 

Americas

 

$

938

 

$

1,010

 

(7.1

)%

Europe/Middle East/Africa

 

467

 

488

 

(4.2

)

Asia Pacific

 

297

 

343

 

(13.5

)

 

Americas revenue of $938 million decreased $72 million, or 7.1 percent, in 2017 as compared to 2016, driven primarily by a decline in operating lease revenue of $58 million.

 

EMEA revenue of $467 million decreased $21 million, or 4.2 percent, in 2017 as compared to 2016, driven primarily by a decline in operating lease revenue of $17 million.

 

Asia Pacific revenue of $297 million decreased $46 million, or 13.5 percent, in 2017 as compared to 2016, driven primarily by a decline in operating lease revenue of $29 million.

 

Total Expense and Other (Income)

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/
Margin

 

For the year ended December 31:

 

2017

 

2016

 

Change

 

Total expense and other (income)

 

 

 

 

 

 

 

Selling, general and administrative

 

$

378

 

$

388

 

(2.7

)%

Provisions for credit losses

 

15

 

72

 

(78.7

)

Other (income) and expense

 

(39

)

(9

)

317.3

 

Total expense and other (income)

 

$

354

 

$

450

 

(21.4

)%

Total expense-to-revenue ratio

 

20.8

%

24.5

%

(3.7

)pts.

 

Total expense and other (income) of $354 million in total expense decreased $96 million, or 21.4 percent, in 2017 as compared to 2016. For additional information regarding total expense and other (income), see the following analysis by category.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Selling, General and Administrative

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/
Margin

 

For the year ended December 31:

 

2017

 

2016

 

Change

 

Selling, general and administrative expense

 

 

 

 

 

 

 

Selling, general and administrative - other

 

$

132

 

$

141

 

(6.2

)%

Contracted services

 

28

 

24

 

13.4

 

Functional support services and other related party expenses

 

218

 

223

 

(2.3

)

Total selling, general and administrative expense

 

$

378

 

$

388

 

(2.7

)%

 

Total SG&A expense decreased $11 million, or 2.7 percent, as compared to 2016, due to a decrease in SG&A-other expense of $9 million, a decrease in functional support services expense charged to the company by IBM of $5 million, partially offset by an increase in contracted services expense of $3 million. For additional information on support expenses charged by IBM, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

Provision for Credit Losses

 

Provisions for credit losses decreased $56 million, or 78.7 percent, as compared to 2016, due to higher general reserves in Brazil in 2016, partially offset by higher specific reserves in Europe in 2017. For additional information on provisions for credit losses, see note E, “Financing Receivables, Receivables Purchased/Participated from IBM,” to the Consolidated Financial Statements.

 

Other (Income) and Expense

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/Margin

 

For the year ended December 31:

 

2017

 

2016

 

Change

 

Other (income) and expense

 

 

 

 

 

 

 

Foreign currency transaction (gains)/losses

 

$

(214

)

$

73

 

$

NM

 

(Gains)/losses on derivative instruments

 

240

 

(70

)

NM

 

(Gains)/losses on sale of equipment upon lease termination

 

(117

)

(37

)

(214.7

)%

Other expense and (income)

 

52

 

24

 

114.8

%

Total other (income) and expense

 

$

(39

)

$

(9

)

$

317.3

%

 

NM - Not Meaningful

 

Total other (income) and expense was income of $39 million, an increase of $29 million in 2017 as compared to 2016. Other (income) and expense includes losses on derivative instruments of $240 million, partially offset by foreign currency transaction gains of $214 million in 2017. The losses from foreign currency transactions of $73 million in the prior year were partially offset by gains on derivative instruments of $70 million in 2016. For additional information on currency impacts and derivative instruments, see note D, “Financial Instruments,” to the Consolidated Financial Statements. The increase in gains on sale of equipment was driven by a higher level of sales of equipment to IBM upon early lease termination primarily due to client migration to IBM’s z14 mainframe during the fourth quarter of 2017. Other expense and (income) increased year-to-year due primarily to credit insurance recoveries in the Commercial Financing portfolio recognized as other (income) in the prior year.

 

Income Taxes

 

The continuing operations effective tax rate for 2017 was 0.6 percent, a decrease of 30.2 points, as compared to 2016. The fourth quarter net benefit of $162 million related to the impact of the enactment of the U.S. Tax Cuts and Jobs Act resulted in a decrease to

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

the effective tax rate of 21.4 percent. Without this benefit, the continuing operations tax rate would have been 22.1 percent, as compared to 30.8 percent in 2016, with the remaining change in the rate year to year driven by the following factors:

 

·                  A benefit due to the geographic mix of pre-tax earnings in 2017 of 11.3 points; partially offset by

 

·                  An increase in year-to-year valuation allowances in certain foreign separate income tax returns of 1.7 points, and

 

·                  An increase due to the establishment of reserves for uncertain tax liabilities related to certain foreign separate income tax returns of 0.8 points.

 

Results of Discontinued Operations

 

The U.S. remanufacturing and remarketing business was divested to IBM at December 31, 2016, and therefore, is reflected as discontinued operations in 2016. The income from discontinued operations, net of tax, in 2016 was $131 million. There was no gain or loss recognized on the divestiture in 2016. There was no income from discontinued operations in 2017. For additional information, see note N, “Discontinued Operations,” to the Consolidated Financial Statements.

 

Financial Position Summary

 

The company’s primary use of funds is to originate financing receivables and operating leases with end-users, suppliers, distributors, resellers and IBM. Financing receivables consist of direct financing leases and loans to end-user clients, purchases of installment payment plans from IBM and working capital financing to suppliers, distributors and resellers. Operating leases are for IBM and OEM IT products. Receivables purchased/participated from IBM include purchased interests in certain of IBM’s trade accounts receivable and IBM receivables that have been participated to IBM Credit. Financing receivables from IBM include loan financing to IBM’s Technology Services & Cloud Platforms’ segment. For additional information relating to financing activities with IBM, see note C, “Relationship with IBM and Related Party Transactions.”

 

Total assets of $39,516 million at December 31, 2017, increased $4,237 million (including an increase of $1,520 million from currency), as compared to year-end 2016, driven by:

 

·                  An increase in net financing receivables of $1,385 million (including an increase of $926 million from currency) primarily driven by Commercial Financing originations; and

 

·                  An increase in receivables purchased/participated from IBM of $1,342 million (including an increase of $236 million from currency) driven by an increase in receivable interests participated from IBM; and

 

·                  An increase in cash and cash equivalents of $908 million (including an increase of $48 million from currency); and

 

·                  An increase in other receivables from IBM of $542 million (including an increase of $178 million from currency) primarily relating to an increase in excess cash invested with IBM; and

 

·                  An increase in financing receivables from IBM of $229 million (including an increase of $92 million from currency).

 

At December 31, 2017, substantially all Client Financing and Commercial Financing assets were IT related assets, and approximately 54 percent of the total portfolio, excluding financing receivables from IBM and receivables purchased from IBM, was with investment grade clients with no direct exposure to consumers. This investment grade percentage is based on the credit ratings of the companies in the portfolio. Additionally, the company takes actions to transfer exposure to third parties. On that basis, the investment grade content would increase by 17 points to 71 percent.

 

For additional information relating to other receivables with IBM originating from cash invested with IBM, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

Total liabilities of $35,954 million at December 31, 2017, increased $4,378 million (including an increase of $1,077 million from currency), as compared to year-end 2016 primarily driven by:

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

·                  An increase in debt with third parties of $5,055 million (including an increase of $6 million from currency) driven by the third-quarter 2017 debt securities issuance of $3,000 million and an increase in commercial paper of $1,496 million;

 

·                  An increase in accounts payable to IBM of $775 million (including an increase of $29 million from currency) driven primarily by higher volumes transacted late in the fourth quarter year-to-year in the Client Financing and Commercial Financing portfolios; partially offset by

 

·                  A decline in debt payable to IBM of $1,608 million (including an increase of $977 million from currency).

 

Total Member’s interest of $3,562 million decreased $141 million from December 31, 2016, as a result of:

 

·                  Net transfers to IBM ($942 million) and distributions to IBM ($437 million); partially offset by

 

·                  Increases from net income ($750 million), foreign currency translation ($365 million) and contributions from IBM ($121 million).

 

Originations of Financing Receivables and Operating Leases

 

Originations are management’s estimate of the gross additions for Client Financing and Commercial Financing assets. There are no industry standards or requirements governing the reporting of financing asset originations. Management believes that the estimated values of financing asset originations disclosed in the table below provide insight into the potential future cash flows and earnings of the company.

 

The Client Financing origination values presented below exclude the company’s loans to IBM’s Technology Services & Cloud Platforms segment, which are executed under a loan facility and are not considered originations.

 

Originations

 

 

 

 

 

 

 

Yr.-to-Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2017

 

2016

 

Change

 

Client Financing

 

$

13,191

 

$

11,611

 

13.6

%

Commercial Financing 1

 

63,019

 

53,983

 

16.7

%

Total originations

 

$

76,210

 

$

65,594

 

16.2

%

 


(1) Commercial Financing originations in 2016 were recast to conform with a change in currency calculation methodology in 2017.

 

For the year ended December 31, 2017, the company originated $13,191 million of Client Financing leases and loans as compared to $11,611 million for the year ending December 31, 2016. The year-to-year increase of $1,580 million was driven by higher originations in the Americas in part due to client migration to the IBM z14 mainframe. For the year ending December 31, 2017, the company originated $63,019 million of Commercial Financing receivables as compared to $53,983 million for the year ending December 31, 2016. The year-to-year increase of $9,036 million was driven by higher originations primarily in the Americas, mainly due to increases in OEM IT originations with existing OEM suppliers and in IBM originations.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Segment Assets

 

 

 

Client Financing

 

Commercial Financing

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

Yr.-to-Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

 

 

 

 

Percent

 

For the year ended December 31:

 

2017

 

2016

 

Change

 

2017

 

2016

 

Change

 

Financing receivables, net

 

$

14,939

 

$

15,244

 

(2.0

)%

$

11,127

 

$

9,436

 

17.9

%

Equipment under operating leases, net

 

401

 

506

 

(20.8

)

 

 

 

Financing receivables from IBM

 

3,743

 

3,513

 

6.5

 

 

 

 

Receivables purchased/participated from IBM, net

 

3,798

 

2,423

 

56.8

 

1,441

 

1,474

 

(2.3

)

Total assets

 

$

22,880

 

$

21,687

 

5.5

%

$

12,568

 

$

10,911

 

15.2

%

 

Total Client Financing assets of $22,880 million at December 31, 2017 increased $1,194 million as compared to year-end 2016. The increase in Client Financing assets was driven primarily by an increase in participated receivables from IBM as well as financing receivables from IBM. This increase was offset by a decline in net financing receivables driven by cash collections in excess of new originations within the lease portfolio and declines in operating leases due to lower originations and asset sales.

 

Total Commercial Financing assets of $12,568 million at December 31, 2017 increased $1,657 million as compared to year-end 2016. The increase in Commercial Financing assets was driven by new originations exceeding cash collections, partially offset by a decrease in purchased receivables from IBM. The growth in new originations was primarily driven by increased volumes with existing OEM IT suppliers. The reduction in purchased receivables from IBM was due to a decrease in purchased interests in certain of IBM’s trade accounts receivable.

 

The company’s receivables portfolio at December 31, 2017 represented the following industry profile: Financial (33 percent), Government (15 percent), Manufacturing (13 percent), Services (13 percent), Retail (8 percent), Communications (6 percent), Healthcare (6 percent) and Other (6 percent). The company’s receivables portfolio at December 31, 2016 represented the following industry profile: Financial (34 percent), Government (14 percent), Manufacturing (13 percent), Services (12 percent), Retail (8 percent), Communications (7 percent), Healthcare (6 percent) and Other (6 percent).

 

For additional information relating to financing receivables with IBM, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements. For additional information on the company’s debt, see note G, “Borrowings,” to the Consolidated Financial Statements.

 

Financing Receivables and Allowances

 

The following table presents net financing receivables excluding residual values and the allowance for credit losses, as well as loan financing to IBM’s Technology Services & Cloud Platforms segment which the company considers collectable and without third party risk.

 

(Dollars in millions)

 

 

 

 

 

At December 31:

 

2017

 

2016

 

Gross financing receivables

 

$

31,004

 

$

28,387

 

Specific allowance for credit losses

 

107

 

148

 

Unallocated allowance for credit losses

 

106

 

130

 

Total allowance for credit losses

 

213

 

277

 

Net financing receivables

 

$

30,791

 

$

28,109

 

Allowance for credit losses coverage

 

0.7

%

1.0

%

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Roll Forward of Financing Receivables Allowance for Credit Losses

 

(Dollars in millions)

 

January 1, 2017

 

Additions

 

Write-offs *

 

Other **

 

December 31, 2017

 

$

277

 

$

15

 

$

(91

)

$

11

 

$

213

 

 

  *  Represents reserved receivables, net of recoveries, that were written off during the period.

**  Primarily represents translation adjustments.

 

The allowance for credit losses on financing receivables at December 31, 2017 was $213 million, or 0.7 percent of gross financing receivables. At December 31, 2016, the allowance for credit losses on financing receivables was $277 million, or 1.0 percent of gross financing receivables.

 

Specific reserves decreased $41 million to $107 million at December 31, 2017 as compared to December 31, 2016, primarily due to write offs of previously reserved receivables in China and Brazil.

 

Unallocated reserves were $106 million at December 31, 2017, a decrease of $23 million as compared to December 31, 2016, primarily due to higher general reserve requirements in Brazil during 2016.

 

Bad debt expense was $15 million in 2017 as compared to $72 million in 2016. The year-to-year decrease in bad debt expense was due to higher reserve requirements in Brazil during 2016.

 

Residual Value

 

Residual value is a risk of the company’s business, and management of this risk is dependent upon the ability to accurately project future equipment values at lease inception. The company has insight into product plans and cycles for IBM products and closely monitors OEM IT product announcements. Based upon this product information, the company continually monitors projections of future equipment values and compares them with the residual values reflected in the portfolio.

 

The company optimizes the recovery of residual values by extending lease arrangements with current clients. Assets returned from lease are sold to IBM at cost, which approximates fair value. In addition, IBM may migrate a client to new technology. In the event this migration results in an early termination of a lease, IBM will purchase the returned equipment from the company at a pre-negotiated price, which is a function of the discounted value of the scheduled future lease payments and the residual value.

 

The following table presents the recorded amount of unguaranteed residual value for direct financing and operating leases at December 31, 2017 and 2016. In addition, the table presents the residual value as a percentage of the related original amount financed and a run out of when the unguaranteed residual value assigned to equipment on leases at December 31, 2017 is expected to be returned to the company. In addition to the unguaranteed residual value, on a limited basis, IBM Credit will obtain guarantees from a third party for the future value of the equipment to be returned at end of lease. While primarily focused on IBM products, guarantees are also obtained for certain OEM IT products. These third-party guarantees are included in minimum lease payments as provided for by accounting standards in the determination of lease classifications for the covered equipment and provide protection against risk of loss arising from declines in equipment values for these assets.

 

The residual value guarantee increases the minimum lease payments that are utilized in determining the classification of a lease as a direct financing lease or operating lease. The aggregate incremental asset value of direct financing leases of IBM equipment with residual value guarantees was $698 million in 2017 and $329 million in 2016, increasing on a year-to-year basis, primarily relating to the IBM Z product announcement in 2017. In addition, the company obtains guarantees from third parties for direct financing leases of OEM IT products. The aggregate incremental asset value of these leases was $153 million in 2017 and $169 million in 2016. The associated aggregate guaranteed future values at the scheduled end of lease of both IBM and OEM IT equipment were $43 million and $19 million for the financing transactions originated in 2017 and 2016, respectively. The cost of guarantees was $4 million and $2 million for the years ended December 31, 2017 and 2016, respectively.

 

25



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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Unguaranteed Residual Value

 

 

 

Total

 

Estimated Run Out of 2017 Balance

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

 

 

2021 and

 

At December 31:

 

2016

 

2017

 

2018

 

2019

 

2020

 

Beyond

 

Direct financing leases

 

$

532

 

$

533

 

$

116

 

$

162

 

$

134

 

$

122

 

Operating leases

 

100

 

76

 

23

 

24

 

18

 

11

 

Total unguaranteed residual value

 

$

632

 

$

610

 

$

139

 

$

187

 

$

151

 

$

133

 

Related original amount financed

 

$

11,510

 

$

10,851

 

 

 

 

 

 

 

 

 

Percentage

 

5.5

%

5.6

%

 

 

 

 

 

 

 

 

 

Consolidated Fourth-Quarter Financial Results

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the fourth quarter ended December 31:

 

2017

 

2016

 

Change

 

Revenue

 

$

427

 

$

439

 

(2.7

)%

Net margin

 

$

280

 

$

281

 

(0.6

)%

Net margin percentage

 

65.4

%

64.0

%

1.4

pts.

Total expense and other (income)

 

$

13

 

$

91

 

(85.7

)%

Income from continuing operations before income taxes

 

$

267

 

$

191

 

39.8

%

Provision for/(benefit from) income taxes 1

 

$

(107

)

$

55

 

NM

 

Income from continuing operations 1

 

$

374

 

$

136

 

175

%

Income from continuing operations margin 1

 

87.5

%

30.9

%

56.6

pts.

Income from discontinued operations, net of tax

 

$

 

$

62

 

NM

 

Net income 1

 

$

374

 

$

198

 

89.3

%

 


(1) The enactment of U.S. tax reform resulted in the company recognizing a provisional net benefit of $162 million in December 2017. The net benefit was primarily the result of the re-measurement of deferred tax balances to the new U.S. federal tax rate as well as the U.S. transition tax and any foreign tax costs on undistributed foreign earnings. As a result, Net Income, Return on Equity and Member’s Interest increased and Debt-to-Equity was reduced in the fourth quarter and for the full-year 2017.

 

NM - Not meaningful

 

Fourth Quarter Financial Performance Summary:

 

In the fourth quarter of 2017, the company delivered revenue of $427 million and income from continuing operations and net income of $374 million. In 2016, the company had revenue of $439 million, income from continuing operations of $136 million and income from discontinued operations, net of tax, of $62 million, resulting in net income of $198 million.

 

Total revenue decreased $12 million, or 2.7 percent, in the fourth quarter of 2017 as compared to the fourth quarter of 2016, driven by a decrease in operating lease revenue of $17 million, or 15.9 percent, partially offset by an increase in financing revenue of $5 million, or 1.7 percent. The decrease in operating lease revenue was primarily due to a decline in average assets due to lower originations and higher asset sales in 2017. The increase in financing revenue was primarily due to an increase in average assets, partially offset by a decline in yields.

 

From a segment perspective, Client Financing revenue of $303 million in the fourth quarter of 2017 declined 11.1 percent as compared to the same period in 2016. The decline was driven by a decrease in financing yields and lower operating lease revenue. Commercial Financing revenue of $124 million in the fourth quarter of 2017 increased 26.2 percent as compared to the same prior-year period. The increase in revenue was driven by an increase in financing yields and average assets.

 

26



Table of Contents

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

From a geographic perspective, revenue in the fourth quarter of 2017 declined in the Americas and Asia Pacific geographies while EMEA grew year to year. Americas revenue of $237 million declined 4.2 percent in the fourth quarter of 2017 as compared to the fourth quarter of 2016, primarily due to a decline in revenue from operating leases. EMEA revenue of $118 million increased 5.3 percent in the fourth quarter of 2017 as compared to the fourth quarter of the prior year, primarily due to an increase in Commercial Financing revenue. Asia Pacific revenue of $73 million decreased 9.2 percent in the fourth quarter of 2017 as compared to the same period in 2016, primarily due to a decline in operating lease revenue.

 

Net margin was $280 million in the fourth quarter of 2017, a decline of $2 million, or 0.6 percent, as compared to the fourth quarter of 2016. The decline year to year was driven by the decrease in revenue noted above and an increase in financing cost, partially offset by a decrease in depreciation expense. The increase in financing cost in the fourth quarter of 2017 was primarily due to an increase in average borrowings and higher interest rates as compared to the fourth quarter of 2016. Depreciation expense decreased $19 million, or 26.2 percent, in the fourth quarter of 2017 as compared to the same period in the prior year, primarily due to declines in the average net investment in operating leases in 2017 as compared to the prior year. Net margin percentage of 65.4 percent in the fourth quarter of 2017 increased by 1.4 points compared to the same period in the prior year.

 

Total expense and other (income) of $13 million decreased $78 million, or 85.7 percent, in the fourth quarter of 2017 compared to $91 million in the fourth quarter of 2016. The year to year decrease in expense and other (income) was driven primarily by an increase in other (income) and expense from the sale of equipment to IBM and a reduction in SG&A, partially offset by an increase in provisions for credit losses. The increase in equipment sales to IBM is driven by a higher level of early lease terminations as a result of client migration to the IBM z14 mainframe.

 

Pre-tax income from continuing operations in the fourth quarter of 2017 of $267 million increased 39.8 percent as compared to the same period in the prior year. The increase in pre-tax income was driven by the decline in total expense and other (income), partially offset by a decrease in net margin. The pre-tax income from continuing operations margin percentage of 62.4 percent in the fourth quarter of 2017 increased on a year-to-year basis by 19.0 points.

 

Income taxes decreased $162 million in the fourth quarter of 2017 compared to the fourth quarter of 2016 due to the enactment of U.S. tax reform in December 2017, resulting in a provisional net benefit of $162 million. The net benefit was primarily the result of the re-measurement of deferred tax balances to the new U.S. federal tax rate as well as the one-time U.S. transition tax and any foreign tax costs on undistributed foreign earnings. For additional information, see note K, “Taxes,” to the Consolidated Financial Statements.

 

Income from continuing operations increased $238 million, or 175.2 percent, in the fourth quarter of 2017 as compared to the same period in 2016, primarily due to the one-time benefit from the enactment of U.S. tax reform. Income from continuing operations margin of 87.5 percent in the fourth quarter of 2017 increased 56.6 points year to year. The continuing operations effective tax rate was (40.3) percent in the fourth quarter of 2017 as compared to 28.7 percent in the fourth quarter of 2016, driven primarily by the one-time benefit from the enactment of U.S. tax reform.

 

Net income increased $176 million in the fourth quarter of 2017 as compared to the fourth quarter of 2016. The increase was primarily driven by the decrease in the effective tax rate in fourth quarter of 2017 as noted above and the increase in other (income) and expense in the fourth quarter year-to-year, partially offset by the decline in net profit from discontinued operations of $62 million related to the company’s divestiture of its U.S. remanufacturing and remarketing business to IBM as of December 31, 2016. For additional information, see note N, “Discontinued Operations,” to the Consolidated Financial Statements.

 

Results of Continuing Operations

 

Segment Details

 

The following is an analysis of the reportable segment results for the fourth quarter ended December 31, 2017, as compared to the fourth quarter ended December 31, 2016. The table below presents each reportable segment’s revenue and net margin results. Segment pre-tax income is the income from continuing operations before income taxes and excludes income from discontinued operations.

 

27



Table of Contents

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/
Margin

 

For the fourth quarter:

 

2017

 

2016

 

Change

 

Client Financing

 

 

 

 

 

 

 

Revenue

 

$

303

 

$

341

 

(11.1

)%

Net margin

 

187

 

209

 

(10.4

)%

Net margin percentage

 

61.7

%

61.2

%

0.5

pts.

Pre-tax income

 

$

209

 

$

156

 

33.8

%

Pre-tax margin

 

68.9

%

45.8

%

23.1

pts.

Commercial Financing

 

 

 

 

 

 

 

Revenue

 

$

124

 

$

98

 

26.2

%

Net margin

 

92

 

73

 

27.3

%

Net margin percentage

 

74.4

%

73.8

%

0.6

pts.

Pre-tax income

 

$

58

 

$

35

 

66.9

%

Pre-tax margin

 

46.5

%

35.2

%

11.3

pts.

Total Segments

 

 

 

 

 

 

 

Total revenue

 

$

427

 

$

439

 

(2.7

)%

Net margin

 

280

 

281

 

(0.6

)%

Net margin percentage

 

65.4

%

64.0

%

1.4

pts.

Pre-tax income

 

$

267

 

$

191

 

39.8

%

Pre-tax margin

 

62.4

%

43.4

%

19.0

pts.

 

Client Financing

 

Client Financing revenue of $303 million in the fourth quarter of 2017 decreased by $38 million, or 11.1 percent, as compared to the same period in 2016. The decrease in revenue was driven by a decline in yields, partially offset by an increase in average client financing receivables. Operating lease revenue declined $17 million mainly due to a decline in average assets during 2017 as a result of a decrease in originations and asset sales to third parties.

 

Net margin decreased $22 million, or 10.4 percent, as compared to the same period in 2016. The decrease was driven by the revenue decline noted above and an increase in interest expense of $3 million, partially offset by a decrease in depreciation of $19 million. The decrease in depreciation was due to the decline in operating lease average asset balances during the year as noted above. The increase in interest expense was due to an increase in average asset balances and an increase in interest rates.

 

Pre-tax income in the fourth quarter of 2017 increased $53 million, or 33.8 percent, as compared to the fourth quarter of 2016. The increase was primarily driven by an increase in other (income) from the sale of equipment to IBM of $68 million and a reduction in SG&A of $22 million, partially offset by the decrease in the net margin mentioned above and an increase in provisions for credit losses of $19 million. The increase in other (income) is mainly driven by equipment sales to IBM due to a higher level of early lease terminations as a result of client migration to the IBM z14 mainframe. The decline in SG&A expense was driven primarily by a decrease in SG&A-other expense of $18 million and lower functional support services charged by IBM of $5 million in 2017. The increase in the provision for credit losses in the fourth quarter of 2017 compared to the fourth quarter of 2016 was due to higher specific reserves in Europe in the current year.

 

Commercial Financing

 

Commercial Financing revenue of $124 million in the fourth quarter of 2017 increased $26 million, or 26.2 percent, as compared to the same period in 2016. The growth in revenue was driven by an increase in yields and an increase in average asset balances with Commercial Financing clients due to an increase in volumes primarily with existing OEM IT suppliers.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Net margin increased $20 million, or 27.3 percent, in the fourth quarter of 2017 as compared to the same period in 2016. The increase was driven by the growth in revenue noted above, partially offset by an increase in interest expense of $6 million due to an increase in average asset balances and an increase in interest rates.

 

Pre-tax income in the fourth quarter of 2017 increased $23 million, or 66.9 percent, as compared to the fourth quarter of 2016, driven primarily by an improvement in net margin of $20 million and a decrease in provision for credit losses of $5 million.

 

Geographic Revenue

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent

 

For the fourth quarter ended December 31:

 

2017

 

2016

 

Change

 

Revenue

 

$

427

 

$

439

 

(2.7

)%

Geographies

 

 

 

 

 

 

 

Americas

 

$

237

 

$

247

 

(4.2

)%

Europe/Middle East/Africa

 

118

 

112

 

5.3

 

Asia Pacific

 

73

 

80

 

(9.2

)

 

Americas revenue of $237 million decreased $10 million, or 4.2 percent, in the fourth quarter of 2017 as compared to the same period in 2016, driven primarily by declines in operating lease revenue of $12 million.

 

EMEA revenue of $118 million increased $6 million, or 5.3 percent, in the fourth quarter of 2017 as compared to the fourth quarter of 2016, driven primarily by an increase in commercial financing revenue, partially offset by declines in client financing revenue.

 

Asia Pacific revenue of $73 million decreased $7 million, or 9.2 percent, in the fourth quarter of 2017 as compared to the same period in 2016, primarily driven by a decline in operating lease revenue of $4 million.

 

Total Expense and Other (Income)

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/
Margin

 

For the fourth quarter ended December 31:

 

2017

 

2016

 

Change

 

Total expense and other (income)

 

 

 

 

 

 

 

Selling, general and administrative

 

$

75

 

$

101

 

(26.0

)%

Provisions for/(benefits from) credit losses

 

5

 

(10

)

NM

 

Other (income) and expense

 

(66

)

0

 

NM

 

Total expense and other (income)

 

$

13

 

$

91

 

(85.7

)%

Total expense-to-revenue ratio

 

3.0

%

20.7

%

(17.6

)pts.

 

NM - Not meaningful

 

Total expense and other (income) of $13 million in expense decreased $78 million, or 85.7 percent, in the fourth quarter of 2017 as compared to the prior-year fourth quarter. For additional information regarding total expense and other (income), see the following analysis by category.

 

29



Table of Contents

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Selling, General and Administrative

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/
Margin

 

For the fourth quarter ended December 31:

 

2017

 

2016

 

Change

 

Selling, general and administrative expense

 

 

 

 

 

 

 

Selling, general and administrative - other

 

$

25

 

$

43

 

(42.4

)%

Contracted services

 

5

 

8

 

(40.0

)

Functional support services and other related party expenses

 

45

 

50

 

(9.4

)

Total selling, general and administrative expense

 

$

75

 

$

101

 

(26.0

)%

 

SG&A decreased $26 million in the fourth quarter of 2017, driven by a decrease in SG&A-other expense of $18 million, a decrease in functional support services expense charged by IBM of $5 million and contracted services expense of $3 million.

 

Provision for Credit Losses

 

Provisions for credit losses increased $15 million in the fourth quarter of 2017 as compared to the fourth quarter of 2016, primarily due to higher specific reserves in Europe in the current year. For additional information on provisions for credit losses, see note E, “Financing Receivables, Receivables Purchased/Participated from IBM,” to the Consolidated Financial Statements.

 

Other (Income) and Expense

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/
Margin

 

For the fourth quarter ended December 31:

 

2017

 

2016

 

Change

 

Other (income) and expense

 

 

 

 

 

 

 

Foreign currency transaction (gains)/losses

 

$

(3

)

$

74

 

NM

 

(Gains)/losses on derivative instruments

 

(4

)

(70

)

(93.7

)%

(Gains)/losses on sale of equipment upon lease termination

 

(78

)

(10

)

NM

 

Other

 

19

 

6

 

224.3

%

Total other (income) and expense

 

$

(66

)

$

0

 

NM

 

 

NM - Not Meaningful

 

Other (income) and expense was $66 million in income in the fourth quarter of 2017. Other (income) and expense was immaterial in the fourth quarter of 2016. The increase in income in the fourth quarter of 2017 was primarily driven by a higher level of sales of equipment to IBM upon early lease termination, mainly due to client migration to the IBM z14 mainframe. In the fourth quarter of 2017, the gains from foreign currency transactions and derivative instruments were $3 million and $4 million, respectively. In the fourth quarter of the prior year, losses from foreign currency transactions of $74 million were mainly offset by gains from derivative instruments of $70 million. For additional information, see note D, “Financial Instruments,” to the Consolidated Financial Statements.

 

Income Taxes

 

The continuing operations effective tax rate for the fourth quarter of 2017 was (40.3) percent, a decrease of 68.9 points, as compared to the fourth quarter of 2016. The year-to-year decline in the effective tax rate in the period was primarily resulting from the enactment of U.S. tax reform in December 2017.

 

30



Table of Contents

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Results of Discontinued Operations

 

The U.S. remanufacturing and remarketing business was divested to IBM at December 31, 2016, and therefore, is reflected as discontinued operations in the fourth quarter of 2016. The net income from discontinued operations in the fourth quarter of 2016 was $62 million. There was no gain or loss recognized on the divestiture in 2016. For additional information, see note N, “Discontinued Operations,” to the Consolidated Financial Statements.

 

Cash Flow

 

The company generated $427 million in cash flow from operating activities in the fourth quarter of 2017, an increase of $22 million as compared to the same period in the prior year. Net cash used in investing activities of $1,457 million in the fourth quarter of 2017 was $4,875 million higher when compared to net cash provided in the fourth quarter of 2016 of $3,419 million. This was driven by lower cash sourced from other receivables from IBM of $4,384 million and increased Commercial Financing originations in the current year. Net cash provided by financing activities of $1,812 million increased $5,555 million in the fourth quarter of 2017 compared to the same period in 2016 driven by year-to-year improvements from debt transactions with related parties of $3,353 million, the issuance of $1,496 million of commercial paper in 2017, and lower cash used in net equity transactions with IBM of $667 million.

 

In the third quarter of 2016, $5.7 billion was invested with IBM and was subsequently borrowed by the company in the form of short-term debt in multiple currencies. These amounts were settled early in the fourth quarter of 2016 and are presented as separate cash flows. The cash invested with IBM is reflected within other receivables with IBM within investing activities and the subsequent borrowing from IBM is reflected within short-term borrowings from/(repayments to) IBM-net within financing activities in the Consolidated Statement of Cash Flows as there was no netting arrangement in place at September 30, 2016.

 

31



Table of Contents

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Prior Year in Review

 

The following section provides a summary of the company’s consolidated financial results in 2016 as compared to 2015.

 

 

 

 

 

 

 

Yr.-to-Yr.

 

 

 

 

 

 

 

Percent/

 

(Dollars in millions)

 

 

 

 

 

Margin

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Revenue

 

$

1,840

 

$

2,074

 

(11.2

)%

Net margin

 

$

1,170

 

$

1,229

 

(4.9

)%

Net margin percentage

 

63.6

%

59.3

%

4.3

pts.

Total expense and other (income)

 

$

450

 

$

446

 

0.9

%

Income from continuing operations before income taxes

 

$

719

 

$

783

 

(8.1

)%

Provision for income taxes

 

$

222

 

$

311

 

(28.7

)%

Income from continuing operations

 

$

498

 

$

472

 

5.4

%

Income from continuing operations margin

 

27.0

%

22.8

%

4.3

pts.

Income from discontinued operations, net of tax

 

$

131

 

$

255

 

(48.6

)%

Net income

 

$

629

 

$

727

 

(13.6

)%

 

 

 

 

 

 

 

Yr.-to-Yr.

 

(Dollars in millions)

 

 

 

 

 

Percent

 

At December 31:

 

2016

 

2015

 

Change

 

Total Assets

 

$

35,279

 

$

35,691

 

(1.2

)%

Total Liabilities

 

$

31,577

 

$

31,958

 

(1.2

)%

Total Member’s Interest

 

$

3,703

 

$

3,733

 

(0.8

)%

 

At December 31:

 

2016

 

2015

 

Debt-to-Equity Ratio *

 

7.3

x

7.3

x

 


* The debt-to-equity ratio is calculated by dividing the total amount of debt outstanding by the total amount of Member’s interest in the company at the end of the reporting period presented.

 

Return on Equity

 

(Dollars in millions)

 

 

 

 

 

At December 31:

 

2016

 

2015

 

After tax income from continuing operations (1)

 

$

498

 

$

472

 

Average equity * (2)

 

$

3,639

 

$

3,704

 

Return on equity (1)/(2)

 

13.7

%

12.7

%

 


* Average of the ending balance of Member’s interest for the last five quarters on a continuing operations basis.

 

32



Table of Contents

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Financial Performance Summary for 2016 and 2015:

 

In 2016, the company delivered revenue of $1,840 million, income from continuing operations of $498 million and income from discontinued operations, net of tax, of $131 million, resulting in net income of $629 million. In 2015, the company had revenue of $2,074 million, income from continuing operations of $472 million and income from discontinued operations, net of tax, of $255 million, resulting in net income of $727 million. In 2016 and 2015, return on equity was 13.7 percent and 12.7 percent, respectively.

 

Total revenue decreased $233 million, or 11.2 percent, in 2016 as compared to 2015, primarily driven by a decrease in financing revenue of $142 million, or 9.5 percent, and a decrease in operating lease revenue of $91 million, or 15.8 percent. The decrease in financing revenue was primarily due to a decline in average assets and a decline in yields from these investments. The decrease in operating lease revenue was mainly due to a decline in originations during 2016.

 

From a segment perspective, Client Financing revenue of $1,455 million in 2016 declined 15.1 percent as compared to $1,714 million in 2015. The decline in revenue was driven by a decrease in average assets, as well as a decline in yields for both capital leases and loans. Commercial Financing revenue of $385 million in 2016 increased 7.3 percent as compared to $359 million in 2015. The increase in revenue in 2016 was driven by an increase in average assets, partially offset by a decline in yields.

 

From a geographic perspective, revenue declined in 2016 in the Americas and EMEA, partially offset by growth in Asia Pacific. Americas revenue of $1,010 million in 2016 declined 17.6 percent as compared to 2015, primarily due to a decline in revenue from operating leases in the U.S. and yields in Brazil. EMEA revenue of $488 million in 2016 declined 4.5 percent as compared to 2015. Asia Pacific revenue of $343 million grew 1.7 percent in 2016 as compared to 2015.

 

Net margin in 2016 was $1,170 million as compared to $1,229 million in 2015. In 2016, net margin decreased $60 million or 4.9 percent, as compared to 2015. The decline in 2016 was driven by the decreases in revenue noted above, partially offset by a decrease in financing cost and depreciation expense. The decrease in financing cost in 2016 was primarily due to declining interest rates partially offset by an increase in average borrowings as compared to 2015. Depreciation expense decreased $71 million or 18.9 percent in 2016 as compared to 2015. The decrease in depreciation expense in 2016  was due to the decline in the average net investment in operating leases in the current year as compared to the prior year. Net margin percentage of 63.6 percent in 2016 increased by 4.3 points compared to the prior year.

 

Total expense and other (income) was $450 million in 2016 as compared to $446 million in 2015. Total expense and other (income) increased $4 million, or 0.9 percent, in 2016 as compared to 2015, primarily due to an increase in SG&A, partially offset by a decrease in provisions for credit losses.

 

Pre-tax income from continuing operations of $719 million in 2016 decreased 8.1 percent in 2016 as compared to 2015. The decrease in pre-tax income in 2016 was primarily driven by the decline in revenue, partially offset by a decrease in financing cost and depreciation expense. Pre-tax income from continuing operations margin percentage of 39.1 percent in 2016 and 37.8 percent in 2015 increased on a year-to-year basis by 1.3 points.

 

Income from continuing operations increased $25 million, or 5.4 percent, in 2016 as compared to 2015. Income from continuing operations margin of 27.0 percent in 2016 increased 4.3 points as compared to 22.8 percent in 2015. The continuing operations effective tax rate was 30.8 percent in 2016 and 39.7 percent in 2015.

 

Net income decreased by $99 million in 2016 on a year to year basis. Net income included a net profit from discontinued operations of $131 million in 2016 and $255 million in 2015 related to the company’s divestiture of its U.S. remanufacturing and remarketing business to IBM in 2016. The decrease in net income in 2016 was primarily due to a decline in net profit from discontinued operations of $124 million in 2016 as compared to 2015. For additional information, see note N, “Discontinued Operations,” to the Consolidated Financial Statements.

 

In 2016, return on equity increased by 0.9 points primarily driven by a lower average equity balance year to year and an increase in net income from continuing operations.

 

At December 31, 2016, the company continued to have the financial flexibility to support the business over the long term. Cash, cash equivalents and cash invested with IBM at December 31, 2016 were $2,222 million, an increase of $689 million from December 31, 2015. Key drivers in the balance sheet and total cash flows were:

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Total assets of $35,279 million at December 31, 2016 decreased $412 million as compared to December 31, 2015, driven primarily by:

 

·                  A decrease in financing receivables of $905 million; partially offset by

 

·                  An increase in other receivables with IBM of $403 million primarily due to an increase in excess cash invested with IBM.

 

Total liabilities of $31,577 million decreased $382 million as compared to December 31, 2015, driven primarily by:

 

·                  A decrease in accounts payable of $415 million, and

 

·                  A decrease in total debt of $219 million; partially offset by

 

·                  An increase in total other liabilities of $502 million.

 

Total Member’s interest of $3,703 million decreased $30 million from December 31, 2015, as a result of:

 

·                  Decreases from net transfers to IBM ($674 million); partially offset by

 

·                  Increases from net income ($629 million).

 

The company’s debt-to-equity ratio at December 31, 2016 of 7.3 to 1 remained flat with the prior year. Total Member’s interest decreased 0.8 percent, while total debt of $27,030 million decreased $219 million, or 0.8 percent.

 

The company generated $1,010 million in cash flow from operating activities in 2016, a decrease of $84 million as compared to the prior year, primarily driven by lower net income performance. Net cash provided by investing activities of $951 million in 2016 was $1,666 million higher as compared to net cash used in investing activities in 2015 of $715 million, primarily driven by a decline in originations year to year ($4,024 million), partially offset by lower collections from financing receivables of $1,260 million and an increase in excess cash invested with IBM of $403 million. Net cash used in financing activities was $1,641 million in 2016 as compared to $176 million in the prior year, driven primarily by higher net transfers to IBM ($791 million) and lower net debt issuances ($674 million) year to year.

 

Results of Continuing Operations

 

Segment Details

 

The following is an analysis of the 2016 and 2015 reportable segment results. The table below presents each reportable segment’s revenue and net margin results. Segment pre-tax income is the income from continuing operations before income taxes and excludes income from discontinued operations.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/
Margin

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Client Financing

 

 

 

 

 

 

 

Revenue

 

$

1,455

 

$

1,714

 

(15.1

)%

Net margin

 

887

 

991

 

(10.5

)%

Net margin percentage

 

60.9

%

57.8

%

3.2

pts.

Pre-tax income

 

$

564

 

$

620

 

(9.1

)%

Pre-tax margin

 

38.7

%

36.2

%

2.6

pts.

Commercial Financing

 

 

 

 

 

 

 

Revenue

 

$

385

 

$

359

 

7.3

%

Net margin

 

283

 

239

 

18.6

%

Net margin percentage

 

73.5

%

66.5

%

7.0

pts.

Pre-tax income

 

$

155

 

$

163

 

(4.5

)%

Pre-tax margin

 

40.3

%

45.3

%

(5.0

)pts.

Total Segments

 

 

 

 

 

 

 

Revenue

 

$

1,840

 

$

2,074

 

(11.2

)%

Net margin

 

1,170

 

1,229

 

(4.9

)%

Net margin percentage

 

63.6

%

59.3

%

4.3

pts.

Pre-tax income

 

$

719

 

$

783

 

(8.1

)%

Pre-tax margin

 

39.1

%

37.8

%

1.3

pts.

 

Client Financing

 

Client Financing revenue of $1,455 million in 2016 decreased by $259 million, or 15.1 percent, as compared to 2015. The decrease in revenue was driven by financing leases and loans due to a decline in average assets and a decline in yields from these investments. An increase in revenue from financing receivables from IBM partially offset these declines. The decline in yields was mainly due to declining interest rates in 2016. Operating lease revenue declined $91 million, primarily due to a decline in the investment in operating lease equipment during the year.

 

Net margin decreased $104 million, or 10.5 percent, as compared to 2015. The decrease was primarily driven by the revenue decline noted above, partially offset by a decrease in depreciation of $71 million and a decrease in interest expense of $84 million. The decrease in depreciation was due to the decline in average assets during the year as noted above, and the decrease in interest expense was due to lower funding requirements in higher interest rate countries during 2016.

 

Pre-tax income decreased $57 million, or 9.1 percent, in 2016 as compared to 2015. The decrease was primarily driven by a decline in net margin of $104 million and an increase in SG&A expense of $32 million, partially offset by a decline in the provision for credit losses of $84 million. The decline in the provision for credit losses in 2016 was primarily due to lower specific reserve requirements in China, partially offset by higher reserves in Latin America. The increase in SG&A expense in 2016 was due to an increase in functional support expenses charged by IBM. At December 31, 2016, the allowance for credit losses coverage was 1.3 percent, a decrease of 161 basis points as compared to 2015. The decrease in coverage in 2016 was primarily due to the impaired receivables and associated allowance retained by IBM due to IBM’s ongoing collection efforts. For additional information, see note A, “Significant Accounting Policies,” to the Consolidated Financial Statements.

 

Commercial Financing

 

Commercial Financing revenue of $385 million in 2016 increased $26 million, or 7.3 percent, as compared to 2015. The growth in revenue was driven by an increase in average assets with Commercial Financing clients due to an expansion with OEM suppliers. The increase in revenue was partially offset by a decline in yields from these investments during the year due to competitive market conditions and lower interest rates in 2016.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Net margin increased $44 million, or 18.6 percent, as compared to 2015. The increase was primarily driven by an increase in revenue as noted above, and a decrease in interest expense. The decrease in interest expense was due to lower funding requirements in higher interest rate countries in 2016.

 

Pre-tax income decreased $7 million, or 4.5 percent, as compared to 2015 driven by an increase in SG&A expense of $31 million and an increase in the provision for credit losses of $23 million, partially offset by an increase in net margin of $44 million. The increase in the provision for credit losses was driven primarily by an increase in unallocated reserves resulting from an increase in Commercial Financing receivables at the end of the year and an increase in specific reserves.

 

Geographic Revenue

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Revenue

 

$

1,840

 

$

2,074

 

(11.2

)%

Geographies

 

 

 

 

 

 

 

Americas

 

$

1,010

 

$

1,226

 

(17.6

)%

Europe/Middle East/Africa

 

488

 

510

 

(4.5

)

Asia Pacific

 

343

 

337

 

1.7

 

 

Americas revenue of $1,010 million decreased $216 million, or 17.6 percent, in 2016 as compared to 2015, driven by the U.S. and Brazil. The decrease in the U.S. was driven by a decline in operating leases. The decrease in Brazil was driven by a decline in yields and average assets.

 

EMEA revenue of $488 million decreased $23 million, or 4.5 percent, in 2016 as compared to 2015, driven primarily by a decline in operating leases in Germany.

 

Asia Pacific revenue of $343 million increased $6 million, or 1.7 percent, in 2016 as compared to 2015. The increase was driven by an increase in yields for financing leases in Japan and loan financing in Australia.

 

Total Expense and Other (Income)

 

(Dollars in millions)

 

 

 

 

 

Yr.-to-Yr.
Percent/
Margin

 

For the year ended December 31:

 

2016

 

2015

 

Change

 

Total expense and other (income)

 

 

 

 

 

 

 

Selling, general and administrative

 

$

388

 

$

325

 

19.3

%

Provisions for credit losses

 

72

 

133

 

(46.1

)

Other (income) and expense

 

(9

)

(12

)

(23.0

)

Total expense and other (income)

 

$

450

 

$

446

 

0.9

%

Total expense-to-revenue ratio

 

24.5

%

21.5

%

3.0

pts.

 

Total expense and other (income) of $450 million increased $4 million, or 0.9 percent, in 2016 as compared to 2015.

 

Total SG&A expense increased $63 million, or 19.3 percent, as compared to 2015, primarily driven by an increase in functional support expenses charged by IBM. For additional information, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

 

Provisions for credit losses decreased $61 million, or 46.1 percent, as compared to 2015, due to lower specific reserve requirements in China, partially offset by higher reserves in Latin America in the current year. For additional information on provisions for credit losses, see note E, “Financing Receivables, Receivables Purchased/Participated from IBM,” to the Consolidated Financial Statements.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Other (income) and expense decreased $3 million, or 23.0 percent, in 2016 as compared to 2015. Other (income) and expense includes higher foreign currency transaction losses of $75 million, partially offset by gains on derivative instruments of $70 million. For additional information on currency impacts and derivative instruments, see note D, “Financial Instruments,” to the Consolidated Financial Statements.

 

Income Taxes

 

The continuing operations effective tax rate for 2016 was 30.8 percent, a decrease of 8.9 points, as compared to 2015. The decline in the effective tax rate in 2016 was largely due to the establishment of certain foreign valuation allowances in 2015.

 

Results of Discontinued Operations

 

The income from discontinued operations, net of tax, of $131 million in 2016 decreased 48.6 percent as compared to 2015, due primarily to a decrease in revenue of 34.5 percent in 2016 as compared to 2015. Pre-tax income decreased 48.6 percent on a year-to-year basis due to the decline in revenue. There was no gain or loss recognized on the divestiture of the U.S. remanufacturing and remarketing business to IBM in 2016. The discontinued operations effective tax rate in 2016 was 39.4 percent, which was relatively flat on a year to year basis. For additional information, see note N, “Discontinued Operations,” to the Consolidated Financial Statements.

 

Other Information

 

Liquidity and Capital Resources

 

IBM Credit funds current and future obligations through the generation of cash flows from operations and its access to the short-term and long-term capital markets, as well as from the support given by IBM’s overall liquidity position and access to capital markets. The debt used to fund the company’s financing assets as of December 31, 2017 was primarily comprised of loans from IBM.

 

Prior to 2017, the company managed its debt-to-equity ratio at approximately 7 to 1. In January 2017, the company increased its debt payable to IBM and made distributions to IBM, which resulted in an increase in the debt-to-equity ratio to approximately 9 to 1.

 

In July 2017, IBM and the company (the Borrowers) entered into a $2.5 billion 364-Day Credit Agreement, and a $2.5 billion Three-Year Credit Agreement (the Credit Agreements). The Credit Agreements permit the Borrowers to borrow up to an aggregate of $5 billion on a revolving basis. Neither Borrower is a guarantor or co-obligor of the other Borrower under the Credit Agreements. Subject to certain conditions stated in the Credit Agreements, the Borrowers may borrow, prepay and re-borrow amounts under the Credit Agreements at any time during the term of the Credit Agreements. Funds borrowed may be used for the general corporate purposes of the Borrowers. Interest rates on borrowings under the Credit Agreements will be based on prevailing market interest rates, as further described in the Credit Agreements. The Credit Agreements contain customary representations and warranties, covenants, events of default, and indemnification provisions. As of December 31, 2017, there were no borrowings under the Credit Agreements. The company incurred charges relating to the Credit Agreements of $1.9 million in 2017 which are recorded in financing costs in the Consolidated Statement of Earnings.

 

In August 2017, IBM Credit established a commercial paper program under which the company is permitted to issue unsecured commercial paper notes from time to time, up to a maximum aggregate amount outstanding at any one time of $5 billion. The proceeds of the commercial paper may be used for general corporate purposes, including, among other items, the repayment of indebtedness and other short-term liquidity needs. The maturity of the commercial paper notes issued may vary but may not exceed 364 days from the date of issuance. The notes are sold under customary terms in the commercial paper marketplace, and can be issued either at a discount from par, or at par, and bear interest rates as agreed upon under the terms and conditions of the agreements between the company and each commercial paper dealer. At December 31, 2017, there was $1,496 million in commercial paper outstanding.

 

In August 2017, the company filed a shelf registration statement with the SEC allowing it to offer for sale public debt securities. In September 2017, the company issued fixed and floating rate debt securities in the aggregate amount of $3,000 million. For additional information of the company’s debt securities, see note G, “Borrowing,” to the Consolidated Financial Statements.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

The consolidated tangible net worth of the company was $3,423 million and $3,580 million as of December 31, 2017 and 2016, respectively, with consolidated tangible net worth calculated as total assets of IBM Credit and its consolidated subsidiaries less the intangible assets and total liabilities of IBM Credit and its consolidated subsidiaries.

 

During 2017, IBM Credit made total distributions to IBM of $531 million, including a return of profit, and received contributions from IBM of $121 million, while maintaining a debt-to-equity ratio of approximately 9 to 1. Included in the $531 million in cash distributions to IBM during 2017 is $94 million distributed in the first quarter of 2017 prior to the company converting to the consolidated basis of reporting and is recorded in net transfers to IBM in the Consolidated Statement of Cash Flows and Consolidated Statement of Member’s Interest. The future amount of third-party debt and contributions from and distributions to IBM may vary as the company continues to manage leverage to the targeted debt-to-equity ratio of 9 to 1. The company’s actual debt-to-equity ratio may vary based on several factors, including differences between management’s expectations and actual results of operations.

 

The company’s Credit Agreements each contain significant debt covenants, which obligate the company to promptly pay principal and interest, limit the aggregate amount of secured indebtedness and sale and leaseback transactions to 10 percent of IBM’s consolidated net tangible assets, and restrict the ability of the company or IBM to merge or consolidate with a third party, unless certain conditions are met. The Credit Agreements also include several financial covenants, including that (i) the company will not permit its tangible net worth to be less than $50 million as of the end of the fiscal year and (ii) the company’s leverage ratio cannot be greater than 11 to 1 as of the last day of each fiscal quarter. The Credit Agreements each contain a cross default provision with respect to other defaulted indebtedness of at least $500 million. The company’s indenture governing its debt securities contains significant covenants which obligate the company to promptly pay principal and interest, limit the aggregate amount of liens (other than permitted liens) to 15 percent of the company’s consolidated net tangible assets, and restrict the company’s ability to merge or consolidate unless certain conditions are met.

 

The company is in compliance with all of its significant debt covenants and is obligated to provide periodic certifications to its lenders. The failure to comply with its debt covenants could constitute an event of default. If certain events of default were to occur, the principal and interest on the debt to which any event of default applied would become immediately due and payable. The Borrowers are also restricted from amending, modifying or terminating the Support Agreement in any manner materially adverse to the lenders. For additional information on the Support Agreement, see note C, “Relationship with IBM and Related Party Transactions”, to the Consolidated Financial Statements.

 

The major rating agencies’ ratings on the company’s debt securities appear in the table below. IBM Credit is a strong investment grade company with significant financial flexibility to execute its strategy.

 

The company does not have “ratings trigger” provisions in its debt covenants or documentation which would allow the holders to declare an event of default and seek to accelerate payments thereunder in the event of a change in credit rating.

 

 

 

STANDARD

 

MOODY’S

 

 

 

 

AND

 

INVESTORS

 

FITCH

 

 

POOR’S

 

SERVICE

 

RATINGS

Long-term debt

 

A+

 

A1

 

A+

Commercial paper

 

A-1

 

Prime-1

 

F1

 

In the normal course of business, the company may be exposed to the impact of foreign currency fluctuations and interest rate changes. Although the company seeks to substantially match fund the term, currency and interest rate variability of its debt against its underlying financing assets, risks may arise from a mismatch between assets and the related liabilities used for funding. The company also employs a rigorous process to optimize portfolio risk management. Portfolio risks include credit and residual value risk. For additional information on the management of these risks by the company, see note A, “Significant Accounting Policies,” and note D, “Financial Instruments,” to the Consolidated Financial Statements, as well as the section entitled “Portfolio Risk Management” in Item 1, “Business,” and Item 7A, “Quantitative and Qualitative Disclosure About Market Risks”.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Cash Flow and Liquidity Trends

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

For the years ended December 31:

 

2017

 

2016

 

2015

 

2014

 

Net cash provided by operating activities 1

 

$

1,034

 

$

1,010

 

$

1,094

 

$

1,001

 

Cash and cash equivalents

 

2,680

 

1,772

 

1,487

 

1,301

 

Cash invested with IBM, available on-demand 2

 

911

 

450

 

46

 

105

 

Committed credit facilities 3

 

$

5,000

 

$

N/A

 

$

N/A

 

$

N/A

 

 


(1) Net cash provided by discontinued operations includes $120 million, $273 million and $210 million in 2016, 2015 and 2014, respectively. For additional information, see note N, “Discontinued Operations,” to the Consolidated Financial Statements. 

(2) Excess cash is periodically invested in interest bearing, on-demand accounts with IBM and is presented as other receivables from IBM in the Consolidated Statement of Financial Position and the Consolidated Statement of Cash Flows. For additional information, see note C, “Relationship with IBM and Related Party Transactions,” to the Consolidated Financial Statements.

(3) The $2.5 billion 364-Day Credit Agreement and $2.5 billion Three-Year Credit Agreement were entered into on July 20, 2017.

 

N/A - Not Applicable

 

Net cash provided by operating activities in 2017 increased $25 million as compared to 2016, driven primarily by the following factors:

 

·                  A decrease in interest payments on debt of $32 million, and

 

·                  A decrease in income tax payments of $25 million, and

 

·                  A decrease in selling, general, and administrative expenditures; partially offset by

 

·                  A decrease in cash provided from discontinued operations.

 

Net cash used in investing activities in 2017 increased $2,433 million as compared to 2016 driven by:

 

·                  Lower collections of financing receivables of $1,187 million, and

 

·                  Increases in financing receivable originations of $1,028 million, and

 

·                  Higher cash used in short-term financing receivables of $468 million, driven by increased Commercial Financing originations year to year; partially offset by

 

·                  Lower net investment in operating leases of $123 million, and

 

·                  Prior year proceeds from the divestiture of the U.S. remanufacturing and remarketing business of $121 million.

 

Net cash provided by financing activities in 2017 increased $2,949 million as compared to 2016 driven by:

 

·                  An increase in cash provided from net debt issuances to third parties of $5,294 million, driven by long-term debt securities issuances of $3,000 million in the third quarter of 2017 and commercial paper issuances of $1,496 million in the fourth quarter of 2017, and

 

·                  Lower cash used in net equity transactions with IBM of $456 million; partially offset by

 

·                  An increase in net cash payments to retire debt with IBM of $2,426 million, and

 

·                  An increase in principal payments on third party long-term debt of $375 million.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Debt

 

(Dollars in millions)

 

 

 

 

 

At December 31:

 

2017

 

2016

 

Short-term debt

 

 

 

 

 

Debt

 

$

1,568

 

$

44

 

Debt payable to IBM

 

15,159

 

16,481

 

Total short-term debt

 

$

16,727

 

$

16,525

 

 

 

 

 

 

 

Long-term debt

 

 

 

 

 

Debt

 

$

4,211

 

$

681

 

Debt payable to IBM

 

9,539

 

9,824

 

Total long-term debt

 

$

13,750

 

$

10,505

 

Total debt

 

$

30,477

 

$

27,030

 

 

Total debt was $30,477 million and $27,030 million at December 31, 2017 and 2016, respectively. Total debt payable to IBM was $24,698 million and $26,306 million at December 31, 2017 and 2016, respectively. Total debt increased $3,447 million at year-end 2017 from year-end 2016 primarily in support of the increase in total assets of $4,237 million at year-end 2017 compared to year-end 2016 and the company’s targeted debt-to-equity ratio of 9 to 1.

 

The company utilizes certain of its financing receivables as collateral for non-recourse borrowings. Financing receivables pledged as collateral for these borrowings was $773 million in 2017 and $689 million in 2016.

 

For additional information on the company’s debt and debt payable to IBM, see note G, “Borrowings,” to the Consolidated Financial Statements.

 

The company’s interest rate and foreign currency rate risk management policies and procedures are discussed in Item 7A, “Quantitative and Qualitative Disclosure About Market Risk,” note A, “Significant Accounting Policies” and note D, “Financial Instruments,” to the Consolidated Financial Statements.

 

Interest on Debt

 

The company recognized interest expense of $362 million and $364 million in 2017 and 2016, respectively, of which $265 million and $301 million was interest expense on debt payable to IBM in 2017 and 2016, respectively. For additional information on interest expense, see note G, “Borrowings,” to the Consolidated Financial Statements.

 

Pre-swap annual contractual maturities of long-term debt and long-term debt payable to IBM outstanding at December 31, 2017, were as follows:

 

(Dollars in millions)

 

 

 

 

 

 

 

 

 

 

 

2023 and

 

 

 

At December 31:

 

2018

 

2019

 

2020

 

2021

 

2022

 

Beyond

 

Total

 

Long-term debt

 

$

610

 

$

1,873

 

$

120

 

$

1,143

 

$

502

 

$

0

 

$

4,248

 

Debt payable to IBM

 

4,614

 

2,284

 

1,861

 

614

 

160

 

6

 

9,539

 

Total

 

$

5,224

 

$

4,157

 

$

1,981

 

$

1,757

 

$

661

 

$

6

 

$

13,786

 

 

Debt-to-Equity

 

The debt-to-equity ratio, as reported in the table below, is, at any given time, the ratio of total debt to total Member’s interest.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

At December 31:

 

2017

 

2016

 

Debt-to-equity ratio

 

8.6

x

7.3

x

 

Total debt changes generally correspond with the level of Client Financing and Commercial Financing receivables, the level of cash and cash equivalents, the change in payables to IBM and external parties and the change in net investment from IBM.

 

The company’s debt-to-equity ratio was 8.6 to 1 at December 31, 2017, which increased as compared to the debt-to-equity ratio of 7.3 to 1 at year-end 2016. Total Member’s interest of $3,562 million declined by $141 million, or 3.8 percent, while debt of $30,477 million increased $3,447 million, or 12.8 percent. The company revised its targeted debt-to-equity ratio in 2017 to 9 to 1 as compared to its target of 7 to 1 in 2016. The targeted debt-to-equity ratio may vary based on several factors, including differences between management’s expectations and actual results of operations. The debt-to-equity ratio was below target at year-end 2017 as a result of the one-time benefit to net income from the enactment of U.S. tax reform.

 

Contractual Obligations

 

 

 

 

 

Payments Due In

 

(Dollars in millions)

 

Total Contractual

 

 

 

 

 

 

 

 

 

At December 31, 2017:

 

Payment Stream

 

2018

 

2019-20

 

2021-22

 

After 2022

 

Long-term debt obligations

 

$

13,786

 

$

5,224

 

$

6,138

 

$

2,418

 

$

6

 

Interest on long-term debt obligations

 

561

 

199

 

303

 

60

 

0

 

Total

 

$

14,347

 

$

5,423

 

$

6,442

 

$

2,478

 

$

6

 

 

Total contractual obligations, as reported in the table above, reflect principal carrying value for the long-term debt and discounted value for the debt interest payments. Interest on floating-rate debt obligations is calculated using the effective interest rate at December 31, 2017, plus the interest rate spread associated with that debt, if any.

 

Off-Balance Sheet Arrangements

 

From time to time, the company may enter into off-balance sheet arrangements as defined by SEC Financial Reporting Release 67, “Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations.”

 

At December 31, 2017 and 2016, the company had no off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources. See the previous table for the company’s contractual obligations, and note J, “Contingencies and Commitments,” to Consolidated Financial Statements for additional information about the company’s guarantees, financial commitments and indemnification arrangements. The company does not have retained interests in assets transferred to unconsolidated entities or other material off-balance sheet interests or instruments.

 

Critical Accounting Estimates

 

The application of GAAP requires the company to make estimates and assumptions about certain items and future events that directly affect its reported financial condition. The accounting estimates and assumptions discussed in this section are those that the company considers to be the most critical to its financial statements. An accounting estimate is considered critical if both (a) the nature of the estimate or assumption is material due to the levels of subjectivity and judgment involved, and (b) the impact within a reasonable range of outcomes of the estimate and assumption is material to the company’s financial condition. The company’s significant accounting policies are described in note A, “Significant Accounting Policies,” to the Consolidated Financial Statements.

 

A quantitative sensitivity analysis is provided where that information is reasonably available, can be reliably estimated and provides material information to investors. The amounts used to assess sensitivity (e.g., 1 percent, 10 percent, etc.) are included to allow users of this report to understand a general direction of cause and effect of changes in the estimates and do not represent management’s predictions of variability. For all of these estimates, it should be noted that future events rarely develop exactly as forecasted, and estimates require regular review and adjustment.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Credit Losses

 

The company reviews its financing receivables portfolio on a regular basis in order to assess collectability and records adjustments to the allowance for credit losses at least quarterly. A description of the methods used by management to estimate the amount of uncollectible receivables is included in note A, “Significant Accounting Policies,” to the Consolidated Financial Statements. Factors that could result in actual receivable losses that are materially different from the estimated reserve include significant changes in the economy, or a sudden change in the economic health of a significant client in the company’s financing and operating lease receivables portfolio.

 

At December 31, 2017, to the extent that actual collectability differs from management’s estimates currently provided for by 10 percent, the company’s pre-tax income would be higher or lower by an estimated $21 million depending upon whether the actual collectability was better or worse, respectively, than the estimates.

 

Determination of Residual Value

 

Residual value represents the estimated fair value of equipment under lease as of the end of the lease. Residual value estimates impact the determination of whether a lease is classified as direct financing or operating. The company estimates the future fair value of leased equipment by using historical models, analyzing the current market for new and used equipment, and obtaining forward-looking product information such as marketing plans and technological innovations. Residual value estimates are periodically reviewed and “other than temporary” declines in estimated future residual values are recognized upon identification.

 

Factors that could cause actual results to materially differ from the estimates include significant changes in the used-equipment market brought on by unforeseen changes in technology innovations and any resulting changes in the useful lives of used equipment.

 

To the extent that actual residual value recovery is lower than management’s estimates by 10 percent, the company’s pre-tax income for December 31, 2017, would have been lower by an estimated $61 million.

 

Income Taxes

 

The company is subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgments are required in determining the consolidated provision for income taxes. During the ordinary course of business, there are many transactions and calculations for which the ultimate tax determination is uncertain.

 

For the company’s U.S. federal and certain state and foreign operations included in various IBM consolidated tax returns and therefore not directly subject to corporate income taxes, IBM makes payments to tax authorities on the company’s behalf. In such cases, IBM and the company maintain a Tax Sharing Agreement for any operations included in an IBM consolidated tax return, pursuant to which IBM charges the company for any taxes owed and reimburses the company for tax attributes generated. Such charges or reimbursements are based upon a calculation of the company’s relevant pro forma stand-alone tax return in which the company records the initial income tax benefits associated with an uncertain tax position using its best estimate at the time the position originates and makes a final settlement of the position with IBM for the recorded amounts. Consequently, any recognition and subsequent changes in assessment about the sustainability of tax positions, including valuation allowances and interest and penalties, are the responsibility of IBM. Because the company bears no risk associated with the sustainability of uncertain tax positions, no uncertain tax liabilities are recorded in the Consolidated Financial Statements for entities that file as part of IBM’s consolidated tax filings.

 

For separate income tax return filings for jurisdictions that are not included in IBM’s tax return, the company recognizes tax liabilities based on estimates of whether additional taxes and interest will be due. These tax liabilities are recognized when, despite the company’s belief that its tax return positions are supportable, the company believes that certain positions may not be fully sustained upon review by tax authorities. The company believes that its accruals for tax liabilities are adequate for all open audit years based on its assessment of many factors, including past experience and interpretations of tax law. This assessment relies on estimates and assumptions, and may involve a series of complex judgments about future events. To the extent that new information becomes available which causes the company to change its judgment regarding the adequacy of existing tax liabilities, such changes to tax liabilities will impact income tax expense in the period in which such determination is made.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

Significant judgment is also required in determining any valuation allowance recorded against deferred tax assets for separate income tax return filing jurisdictions. In assessing the need for a valuation allowance, management considers all available evidence for each jurisdiction including past operating results, estimates of future taxable income and the feasibility of ongoing tax planning strategies. In the event that the company changes its determination as to the amount of deferred tax assets that can be realized, the company will adjust its valuation allowance with a corresponding impact to income tax expense in the period in which such determination is made.

 

The consolidated provision for income taxes will change period to period based on nonrecurring events, such as the settlement of income tax audits and changes in tax laws, as well as recurring factors including the geographic mix of income before taxes, the timing and amount of foreign dividend repatriation, state and local taxes and the effects of various global income tax strategies. To the extent that the provision for income taxes increases/decreases by 1 percent of income from continuing operations before income taxes, consolidated net income would have decreased/improved by $7.5 million in 2017.

 

Cybersecurity

 

While cybersecurity risk can never be completely eliminated, the company’s approach draws on the depth and breadth of IBM’s global capabilities in security services and its internal approaches to risk management.

 

From an enterprise perspective, IBM implements a multi-faceted risk-management approach to identify and address cybersecurity risks. IBM has established policies and procedures that provide the foundation upon which IBM Credit’s infrastructure and data are managed. IBM Credit performs ongoing assessments regarding its technical controls and adheres to IBM’s established methods for identifying emerging risks related to cybersecurity. IBM uses a layered approach with overlapping controls to defend against cybersecurity attacks and threats on networks, end-user devices, servers, applications and cloud solutions. The company also through IBM has a global incident response process to respond to cybersecurity threats. In addition, the company through IBM utilizes a combination of online training, educational tools, social media, and other awareness initiatives to foster a culture of security awareness and responsibility among its workforce.

 

Employees and Related Workforce

 

At December 31, 2017, IBM Credit and its subsidiary companies employed approximately 2,400 people globally.

 

Looking Forward

 

In 2017, IGF’s legal entity structure was reorganized globally to consolidate Client Financing and Commercial Financing under IBM Credit which drives operational benefits. The company has access to the short-term and long-term debt markets as an issuer in the capital markets and as a borrower from IBM. In 2017, the company issued third-party debt and made distributions to IBM, including a return of profit. The company will continue to target a debt-to-equity ratio of 9 to 1, which may vary based on several factors, including differences between management’s expectations and actual results of operations. The future amount of  third-party debt and contributions from and distributions to IBM may vary as the company continues to manage its leverage to the targeted debt-to-equity ratio. Absent other funding alternatives, a protracted period where the company or IBM could not access the capital markets would likely lead to a slowdown in originations. Financing originations, which determine the asset base of the annuity-like business, are also dependent upon the demand for IT products and services as well as client participation rates.

 

The company’s financial position provides flexibility and funding capacity which enables the company to be well positioned in the current environment. The company’s financing assets and new originations result from the financing of IBM and OEM IT products and services to the company’s and IBM’s clients. Substantially all financing assets are IT related assets which provide a stable base of business for future growth. The company’s financing offerings are competitive and available to clients as a result of factors including the company’s borrowing cost, financing incentive programs and access to the capital markets.

 

IBM Credit has policies in place designed to manage the risks involved in financing, including credit losses, residual values, liquidity, currency and interest rates.

 

The economy could impact the credit quality of the company’s receivables portfolio and therefore the level of provision for credit losses. IBM Credit will continue to apply rigorous credit policies in both the origination of new business and the evaluation of the existing portfolio and will take risk mitigation actions when necessary.

 

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – (continued)

 

The company has historically been able to manage residual value risk both through insight into IBM’s product cycles and monitoring of OEM IT product announcements.

 

Interest rates and the overall economy (including currency fluctuations) will have an effect on both revenue and net margin. Interest rates directly impact the company by increasing or decreasing financing revenue and associated borrowing costs. The company’s interest rate risk management policy, combined with its pricing strategy should mitigate margin erosion due to changes in interest rates.

 

The company’s geographically diverse client base, product and client knowledge, and strategy to substantially match fund the term, currency and interest rate variability of its debt to the underlying financing assets should enable prudent management of the business going forward, even during periods of uncertainty with respect to the global economy.

 

Item 7A. Quantitative and Qualitative Disclosure About Market Risk.

 

The company operates in multiple currencies and is a lender and issuer in the capital markets and a borrower from IBM. In the normal course of business, the company may be exposed to the impact of interest rate changes and foreign currency fluctuations. The company limits its exposure to core market risks by following established risk management policies and procedures and through the use of match funding from IBM and third parties. Although the company seeks to substantially match fund the te