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How Lenovo Can Turn Liabilities Into Assets

This article is more than 9 years old.

At IBM , the x86 server business was under-funded, under-appreciated, and under-supported.  As part of Lenovo, however, that same business will be cherished because it will be delivering some of the highest-margin revenues in the entire company.

This apparent paradox underscores the reasoning behind Lenovo’s sudden moves in late January to buy not one but two large businesses within the space of a week.  In addition to agreeing to purchase Big Blue’s x86 server business Jan. 23, the Chinese juggernaut stepped up its high-mobility game on Jan. 29 with an announcement that it will acquire from Google the Motorola division that makes smartphone handsets.

What makes a market?  One company’s reject is another’s potential goldmine.

But Lenovo, which reported earnings of only $265 million on $10.8 billion in revenue in its most recent quarter will have to vacuum cash off its balance sheet, issue new stock, and take on substantial debt to finance the $5.2 billion that its combined acquisitions will cost.  The company does have more than $3 billion in cash and equivalents on its balance sheet, but, given a profit margin of 2.5 %, there will be many calls on that cash besides future debt-service payments.

In February, CEO Yang Yuanqing said Lenovo has “enough resources to deal with both acquisitions,” but traders weren't so sure.  The stock, which peaked just below HK$11 the day of the Motorola announcement was driven under HK$8 in late February.  It has since recovered somewhat, hovering between HK$8.25 and 9.50.  (Lenovo shares are traded in Hong Kong dollars (HK$) on the Hong Kong Stock Exchange.  A HK$ is roughly equivalent to US$0.13.)

Yang was technically correct.  His chief financial officer Wong Wai Ming assured financial analysts that same day that the company has access to $4.7 billion in cash, when secured loans of $1.7 billion are added to the $3 billion on the company’s books.  The cash portion of the two deals will absorb $2.7 billion, leaving $2 billion for operations.  Lean, but not impossible.

So, if we accept that the company will be able to reduce operating costs through internal discipline, obtain economies of scale by combining manufacturing operations (i.e., the Motorola and Lenovo handset businesses, the x86 server and PC businesses), and grow revenues of the acquired businesses, then there seems to be a way forward, however narrow and dangerous it may appear at the moment.

Aside from being able to live with lower margins, though, Lenovo has other reasons for viewing these business, which were mostly trouble for their former owners, as valuable assets.  Lenovo has been the market-share leader in the PC business for nearly a year, and that’s a victory so far as it goes, but the PC business is in decline, and it’s clear that Lenovo must look elsewhere for future growth.

The company has packaged this strategy in its “PC Plus” concept, which envisions a long-term business built on the base of its PC position, but expanding out into other areas, notably enterprise and mobility.  Lenovo has done well in smartphones in its home territory of China, where it is outranked only by Samsung.  It also sells phones in Russia, India, Indonesia, Philippines, Vietnam, and elsewhere, but in North America and Western Europe, the firm’s smartphone business is negligible.  Lenovo will keep the Motorola brand for these major western markets because it still has cachet among consumers in both.  The Lenovo brand (on smartphones) may eventually make it to any or all of these markets, but will be positioned differently.

Thus, the Motorola acquisition looks like a pretty good fit for Lenovo, which knows how to manage low-margin consumer hardware businesses and had a couple of very specific holes to fill.  Google, on the other hand, was a software and advertising company saddled with a hardware business acquired mostly for its patents (which will be shared and licensed to Lenovo as part of the deal).

The x86 server business represents a steeper hill.  Lenovo’s organic enterprise business has been negligible, consisting mostly of selling commodity servers to Chinese customers and commercial notebooks to large businesses around the world, but the IBM unit will place Lenovo in the #3 position worldwide, assuming it can retain existing customers.  So, Lenovo has had access to the enterprise customer set, but not much in the way of products to sell them.  IBM’s jettisoned business gives Lenovo the products it needs to make inroads into this important market.

Among other benefits that Lenovo will derive from this acquisition is a closer relationship with Intel , which makes processors for most of the server market.  Also, the x86 engineers, sales talent, and management will come over to the Chinese company intact, giving it a boost in development capabilities.

Lenovo says it can compete and make money in commodity servers — even against the low-cost Asian white-box server makers.  IBM found the x86 server business to be a boat anchor, given its low margins compared to IBM’s other businesses.

So, one man’s poison is another man’s meat.

But probably the best indication that Lenovo will be able to digest these two large acquisitions is its track record with IBM’s PC business, which Lenovo bought in 2005.  Yes, there has been turmoil in getting to today.  The CEO has been changed out several times over the past few years.  But since Yang took the helm, things have been steady.  Lenovo has retained most of the talent that came with the acquisition, particularly the bread-and-butter, mid-management positions where most of the real work gets done.  Post-acquisition, Lenovo was able to grow revenues and turn a profit, albeit a modest one.

Both the x86 server and the smartphone businesses are some of the most competitive in the world, but Lenovo is built to compete under just such conditions, and, after an initial period of straitened circumstances based on a heavy cash outflow, the company is likely to reemerge with a fuller product portfolio, broader geographic reach, stronger worldwide brand, higher revenues, and, who knows? Maybe a bit of profit as well.

Disclosure: Endpoint has a consulting relationship with Lenovo.

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