Mainland PC-maker Lenovo goes global

$1.75 billion acquisition of IBM division could signal the birth of China''s first global brand

In a historic deal, China's dominant personal computer maker, Lenovo Group, announced today that it paid out $650 million in cash, $600 million in stock, and taken on $500 million in IBM debt in acquiring the US giant's personal computer division (PCD).

The deal means that for the first time ever, a Chinese company will become a global brand. That is a significant move up the value scale of an economy which has proved its manufacturing prowess but has so far failed to obtain recognition in the higher margin, but subtle and tricky art of brand building.

It follows another Chinese deal - the as yet uncompleted $1.9 billion takeover of Britain's MG Rover Group earlier this year by Shanghai's SAIC. However, the carmaker's venture into Britain is perhaps less significant, since the SAIC deal is primarily intended to bolster its fortunes in China rather than to use MG as a launch pad into Europe. Taking over PCD, on the other hand, makes Lenovo a major global player in one swoop. (Domestic M&A in China has reached almost $11 billion so far this year, while foreign acquisitions of Chinese targets amounted to a value $7.9 billion.)

"Lenovo is in many ways the perfect partner for IBM since there is so little overlap," an observer says, since IBM specializes in laptops and servers worldwide, while Lenovo focuses on desktops in China. IBM would thus rather sell to Lenovo than to any of its major Western competitors.

With the organic growth path judged too slow and numerous barriers to international expansion, Lenovo may have pulled off a masterstroke in acquiring one of the world's most valuable brands. The gigantic new entity should help its domestic sales, where it has 27% of the market, thanks to economies of scale, and the popularity of IBM lap tops, a technology in which Lenovo lags badly.

Even more significant than domestic success is the chance to become a branded global player. IBM, despite heavy shrinkage in recent years, still had a global market share of 5.8% last year, which combined with Lenovo's 2.2% will catapult the mainland entity into the No. 3 position globally, behind only Hewlett Packard and Dell on 13.9% and 16.4% respectively.

Renowned IBM products like the ThinkPad and the Thinkcenter will eventually have the Lenovo name placed alongside them, finally guaranteeing that a Chinese brand gets global recognition.

PCD had revenues of $10 billion last year, but the merger will result in revenues of $12 billion next year and a volume of 11.9 million units, equivalent to a four-fold increase in Lenovo's existing PC business.

The benefits of the economies of scale will come on the back of the company's new clout, enabling it to impose important cost savings on its acquisition of LCD screens and DRAMs, leading components in PC assembly. That should lead to savings of $200 million by 2007, and around half that by next year.

Given PCD's negative net asset position, goodwill will be considerable, amounting to about two thirds of the deal size, with the remaining third the value of PCD's intellectual property rights, say bankers.

One specialist says that the pricing of the deal was in line with the valuations accorded to fellow PC makers Dell and Hewlett Packard.

"If you assume a price/earnings of 10-15 times, which is pretty standard for this kind of business, you get a valuation of 1-1.5 billion, and a sales multiple of 0.1-0.15 times," he says.

The key to buying the business was less looking at such multiples than believing that the profit margins were sustainable, he adds.

"Even with an EBIT profit margin of 1%, you are still buying into a business throwing off a cash flow of $100 million. That's very attractive," he says.

The stock sale means that IBM will have an 18.9% passive stake in Lenovo. IBM will be able to exit in four equal-sized sell-offs over three years, with the first installment falling in six months.

While it's possible that IBM may have preferred an all-cash deal, the stock transfer ensures that IBM is incentivized to make the deal a success, says one banker. That includes IBM committing itself to a five-year brand licensing agreement and to working with Lenovo to continue to provide sales, distribution and financing to customers. That cooperation will be essential to permit the mainland company, almost totally inexperienced in international markets, to make a success of the transaction.

IBM will benefit too, since the partnership with Lenovo in China's rapidly growing market means IBM will have a better chance of expanding its sales of high-end servers. It is servers and technology consulting and systems management that increasingly comprise IBM's core business.

Other benefits should come from becoming independent of IBM, to which PCD currently sells a great deal of PCs, but only at cost price.

As a result of the transaction, Lenovo will move from a net cash position to a net debt position, since of the $650 million cash, $500 million will come from bank loans. In terms of debt to total capital, and debt to earnings before interest, tax, depreciation and amortization (EBITDA), Lenovo will come in at 30% and 1.2 times respectively after the deal.

Despite the significance of this deal, it should not blind investors to the difficulties ahead.

The PCD is barely making a profit despite being run by one of the savviest tech companies in the world. If the transaction is to become a success, rather than a testament to the hubris of Lenovo's renowned founder Liu Chuanzhi, the mainland company will be on a learning curve steeper than it has probably ever seen before.

The transaction will be likely be completed in the second quarter of next year.

Goldman Sachs is financial adviser for Lenovo, while Merrill Lynch acts in the same role for IBM.

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