118288603 Case Study on Lenovo and IBM PDF

Preview

Summary

assignment...

Description

Harvard Business School

The Emergence of a Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division

A Final Paper Submitted to Professor Mihir Desai

By

John Ackerly Måns Larsson

Cambridge, MA

December 2005

Introduction On May 1, 2005, the Lenovo Group acquired IBM’s personal computing division (IBM PC) for $1.25 billion, achieving the goal of its ambitious founder, Liu Chuanzhi, to create a global PC manufacturing powerhouse. By transforming itself from an upstart company focused on its domestic market, Lenovo joined an exclusive club of Chinese companies, such as Huawei and TCL, which compete head-to-head with leading multinational corporations. Without the involvement of western private equity firms – Texas Pacific Group (TPG), Newbridge Capital,1 and General Atlantic Partners (GA) – this transaction may never have been consummated.

Each firm brought crucial expertise and credibility that helped mitigate the

significant financial, operational and cultural risks inherent in a large scale, cross-border transaction. Many believe that these efforts opened a new chapter in the growth of China’s economy and its integration with the West. As Bill Grabe, GA’s representative on Lenovo’s board, stated: “Lenovo’s acquisition of IBM mark the start of something bigger. In the future, we will see more Chinese global giants emerging through cross-border M&A.”2 This paper examines the underlying motivations and assumptions of each party in the transaction. While this transaction had many risks, we conclude that the strategic rationale was sound, the ultimate valuation was fair, and that all players are positioned to benefit: IBM shed a resource consuming, non-core asset; Lenovo leapfrogged to global leadership; and, the private equity players negotiated and structured a deal with significant upside potential with limited downside. The paper reaches these conclusions by answering four key questions: •

What was the strategic rationale for and key risks of the acquisition?

•

Why did the private equity buyers get involved in the transaction? What were the underlying motivations of the interested parties?

•

How was the deal structured to address the assumed risks?

•

How did Lenovo think about the valuation of IBM PC? What was the “fair” value of IBM PC at the time of the transaction?

1 Newbridge Capital is an affiliate of TPG. Hereafter, “TPG” will refer to Newbridge as well as the Texas Pacific Group. 2 William Grabe, interview by authors, December 6, 2005.

The Emergence of a Chinese Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division By John Ackerly & Måns Larsson 2/28

SECTION 1: What was the strategic rationale for the acquisition and what were the key risks? Strategic rationale The Lenovo-IBM PC transaction was underpinned by sound industrial logic. The complementary nature of their businesses across geographies, products and areas of functional strength opened a number of win-win opportunities for buyer and seller. As outlined below, though the deal offered significant opportunity for revenue synergies, the cross-border combination ultimately was viewed as “cost play” by the parties involved. When IBM decided to spin out its PC division in April 2004, its motivations were clear: the division recorded a net loss of $258 million in 2003 and $171 million in 2002 and had required a total parent company equity infusion totaling $987 million as of June 2004.3 In addition, the division was an “orphan” within the organization, as it did not fit within IBM’s broader strategy to focus on higher margin enterprise and services businesses. The initial interest in IBM PC came from financial buyers such as TPG who were attracted to the carve-out of IBM PC as a stand alone entity.4 These players sought to realize gains through leverage and achieve significant cost savings, particularly through aggressive procurement rationalization and jettisoning IBM’s expensive back-office support such as call centers and human resource functions. 5 According to Morgan Stanley, IBM PC’s SG&A expense ratio of 10% is significantly higher than the industry average of 6.8%.6

While TPG did not rely on potential

revenue growth to justify the attractiveness of the carve-out opportunity, they did acknowledge the potential upside of bringing focus to IBM PC’s consumer business in emerging markets.7 The strategic rationale for the stand-alone carve-out opportunity holds for the Lenovo-IBM PC business combination and is further enhanced by the fit of the Lenovo and IBM PC businesses. Prior to the transaction, Lenovo was the undisputed leader in the China PC market with 27% market share, a low cost position that resulted in gross margins of 13.3% (versus 10% for IBM PC), 3

Lenovo, December 31, 2004, Circular; Very Substantial Acquisition Relating to the Personal Computer Business of International Business Machines Corporation, Hong Kong Stock Exchange, p. 149, p. 226. 4 William Grabe, interview by authors, December 6, 2005. 5 Winston Wu, interview by authors, December 6, 2005. 6 Victor Ma, Big is Beautiful, Morgan Stanley Equity Research, April 19, 2005, p. 1. 7 Winston Wu, interview by authors, December 6, 2005. The Emergence of a Chinese Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division By John Ackerly & Måns Larsson 3/28

and enjoyed particular strength in the desktop and fast growing consumer market. For example, its handset sales grew 100% in 2004.8 However, it lacked global reach and scale. IBM PC, on the other hand, operated in 160 countries across the globe, was a leading innovator, owned a strong brand – particularly “ThinkPad” in the laptop market – and boasted best-in-class service capabilities.

However, the division had virtually abandoned the consumer business, had a weak

desktop business and limited reach into China.

The business combination would create the 3rd

largest competitor in the PC market with 8% market share across the desktop, laptop and consumer segments supported by unparalleled global sales, marketing, distribution and customer support infrastructure.9 Sales of the combined group outside China were expected to be 72% of total sales, versus 2% for Lenovo on a stand-alone basis. The combined entity’s global infrastructure would help drive cost savings by marrying an efficient supply chain with a low cost manufacturing base. The parties estimated that LenovoIBM’s scale would create cost synergies of $150-200 million a year on procurement savings alone, as Lenovo could get better pricing on such components as Intel chips by purchasing in bulk.10 Analysts have estimated that these procurement savings account for 60-70% of total savings.11 These benefits would be further enhanced by sharing of best practices, consolidation of vendor lists, and increasing the use of standardized parts by consolidating product lines.

In addition,

analysts estimate that Lenovo and IBM would be able consolidate 16 functional areas achieving savings of $10-30 million.12 As mentioned above, Lenovo, IBM and the private equity players also recognized the potential for revenue synergies. Particularly attractive to Lenovo and the private equity investors was the opportunity to sell Lenovo’s low cost consumer products in emerging markets through IBMs extensive distribution network.13 In addition, TPG was optimistic that Lenovo would be able to take market share from Dell and HP in the U.S. consumer market.14 Finally, IBM PC traditionally sold its PCs to its IBM parent at cost. Under the terms of the deal, Lenovo would be able to achieve attractive margins on computers sold to IBM. 8

William Grabe, interview by authors, December 6, 2005. Lenovo, December 31, 2004, Circular; Very Substantial Acquisition Relating to the Personal Computer Business of International Business Machines Corporation, Hong Kong Stock Exchange, p. 149, p. 48. 10 The figure assumes that Lenovo-IBM could get similar terms to Dell and H-P. 11 Max Chen , interview by authors, December 1, 2005. 12 Max Chen , interview by authors, December 1, 2005. 13 William Grabe, interview by authors, December 6, 2005. 14 Winston Wu, interview by authors, Cambridge, MA, December 7, 2005. 9

The Emergence of a Chinese Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division By John Ackerly & Måns Larsson 4/28

Deal risks This section highlights the key risks facing each party. While the industrial logic of the Lenovo-IBM PC was clear, the transaction was fraught with risk. Due to the complex, crosscontinental nature of the deal and the predictable political angst spurred by the announcement, the transaction left the involved parties exposed to significant financial, operational and reputation risk.

Cave-out risks Even on a stand-alone basis, the carve-out of IBM PC from IBM’s operations would pose significant challenges. According to Winston Wu, a member of the TPG deal team, “The carveout of IBM PC is the most complex carve out ever attempted by a private equity firm”15 IBM PC was not organized as a separate stand-alone unit with its own functions within IBM. Rather, IBM PC benefited from centralized functions run by its parent, such as global procurement, sales and distribution as well as back-office support such as accounting, finance and human resources. These intricate links with the parent company added to the difficulty of structuring a share purchase agreement. In order to solve the issue of the IBM PC’s deep dependence on IBM, the transitional services agreements became important components of the negotiations and the transaction. This paper looks at these agreements in some detail in Section 3 below. Lack of financial transparency The dependence of IBM PC on its parent also made it difficult to fully understand its “true” underlying financial performance.

According to PriceWaterhouseCoopers: “The historical

financial statements may…not reflect the results of operations, financial position or cash flows that would have resulted had the [Company] been operated as a separate entity.”16 For example, as discussed above, IBM PC is using its parent’s sales force and distribution channels and relies on its corporate functions. While IBM PC had historically paid its parent for many of these services, it is unclear if the prices paid represented “fair market” prices. Financial dependence of IBM PC on its parent 15

Winston Wu, interview by authors, Cambridge, MA, December 7, 2005. PriceWaterhouseCoopers, “Report of Independent Registered Public Accounting Firm To the Stockholders and Board of Directors of International Business Machines Corporation,” as reprinted in Circular, p. 115. 16

The Emergence of a Chinese Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division By John Ackerly & Måns Larsson 5/28

IBM PC relied on its parent for customer financing. IGF, IBM’s financing arm, originated commercial loans to finance dealer and remarketer purchases of the Company’s products to the tune of US$6.7 billion and US$6.0 billion in 2003 and 2002, respectively. These loans represent over 60% of the Company’s sales. Again, ensuring that IBM PC continued to receive these financial services became a significant issue in the negotiations. Similarly, as a part of the IBM group, IBM PC had access to its parent company’s war chest, which was an essential tool in managing the cyclicality of the business. IBM PC had tremendous intra-quarter working capital swings which approached 10% of annual sales. According to TPB, “[IBM PC’s] intra-quarter working capital swings could be as large as US$1 billion.”17 A big worry for the parties involved in the transaction was to what extent the Company would have sufficient cash and/or credit lines to manage these working capital movements. Integration risks: cultural and operational In addition to the issues specific to a carve-out from IBM, the combination of a Chinese and U.S. firm posed a host of additional risks.

For example, the cultural and operational

integration challenge was significant and could have potentially derailed the deal.

The two

companies had distinct cultures: IBM PC was an established global business with a Western management mindset, whereas Lenovo was a purely China-focused company run by local Chinese entrepreneurs. Further, according to IBM accounting, its PC division had been operating at a loss for years. Lenovo’s management had very limited experience operating outside China, and there was a risk that the key US management needed to run the international portion of the combined business might leave because of potential cultural clashes. As the Economist noted, “Lenovo might make things worse, given cultural differences between Americans and Chinese, big differences in pay and the need for interpreters at every meeting.”18 Indeed, cultural differences have plagued Chinese-Western mergers in the past. Vincent Yan, finance director of TCL, which merged with the French television manufacturer Thomson, has admitted that “the cultural gap proved wider than expected.”19 The integration also presented several operational risks. It would not be an easy task to subsume a global icon operating in 160 countries within a company one third its size that operates 17

Ibid. “Champ or chump?,” The Economist, December 9, 2004, 19 Ibid.

18

The Emergence of a Chinese Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division By John Ackerly & Måns Larsson 6/28

in only one country. Not only would the challenge of combining the two businesses in their current format prove difficult, but also the planned restructuring of the supply chain and manufacturing added significantly to that risk. In particular, successfully executing two major cost initiatives fundamental to the industrial logic of the acquisition was far from assured. Achieving preferential terms from suppliers and fully leverage Lenovo’s low cost infrastructure to reduce the global operating costs very ambitious goals that had never before been attempted by a Chinese company.20 According to Jeannie Chung at CSFB, “so far, no Chinese company has successfully turned loss-making overseas assets into a profitable business.

Lenovo could hardly be an

21

exception.”

An additional question was what would happen to Lenovo after the negotiated services agreements with IBM had disappeared. As this paper discusses in Section 3, the interim services agreements gave Lenovo-IBM PC access to IBM sales network, business partners and distributors as well as its financing arm and its warranty services.

Political risk When the deal was announced there was a loud cry by politicians in the United States. At the outset, there seemed to be a risk that the deal would not get approval.

Several senior

Congressmen lobbied against the deal, claiming that it would “allow the Chinese government to acquire sensitive American technology, and potentially, use IBM’s facilities to spy for the Chinese armed forces.” 22 They cited the fact that the Chinese Academy of Sciences was a major shareholder of the firm. These very same Congressmen wrote to the Treasury Secretary, John Snow, to argue that “the deal may transfer advanced US technology and corporate assets to the Chinese government.” 23 While many viewed these activities as shrill political posturing, the Committee on Foreign Investment in the United States extended its routine 30-day investigation by 45 days to perform a more thorough investigation.

In addition to approval risk, the key players

were concerned that Lenovo-IBM PC would lose IBM PC’s U.S. government contract, which represented approximately 7% of total IBM PC sales.

20

Ibid. Jeannie Cheung, et al., Lenovo Group: Powering Up, April 12, 2005. “I spy spies,” The Economist, ´February 3, 2005. 23 Ibid. 21

22

The Emergence of a Chinese Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division By John Ackerly & Måns Larsson 7/28

Competitive response risk At the time of the deal, the potential negative impact of these uncertainties were compounded by the likely opportunistic response by Dell and Hewlett-Packard, who likely would endevour to target IBM PC customers between the announcement the transaction and a successful close and subsequent integration. A.M. Sacconaghi at Sanford Bernstein Research argued that “the main issue in relation to the sale is the ability of [IBM PC] to retain PC customers, especially over the next six months, before the deal closes, as Dell and Hewlett-Packard will probably aim to capitalize on the uncertainty among IBM customers by aggressively seeking them out.”24 There was a significant risk that the IBM PC brand would be tarnished by the competition as they would try to “steal” the Company’s customers. In addition, by competing head to head with Dell and H-P, IBM PC might have to match aggressive pricing, thereby cutting into the firms profitability. Brand risk Just like there was a worry that a potential political backlash in the US and an attack by IBM PC’s competition could negatively affect sales, there was a concern that the transaction would result in a degradation of the “ThinkPad” brand around the world. Indeed, there was a risk in combining the “high-end” IBM brand with the “lower end” Lenovo brand. How would consumers react to the change of control? IBM Thinkpad stood for quality and “made in America” (even though most production took place offshore even under IBM’s ownership). Furthermore, there was a second degree of brand risk, five years after the transaction when Lenovo would lose the right to use the “IBM” brand. Lenovo’s lack of brand recognition outside of China could require that it spend more than expected on marketing promote its brand in anticipation of the expiration of the five-year term.

24 A.M. Sacconaghi, et al., “IBM: PC Business Sale Immaterial But Risks ‘Growth Gift’ to Rivals,” Bernstein Research, December 17, 2004, p. 1.

The Emergence of a Chinese Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division By John Ackerly & Måns Larsson 8/28

SECTION 2: How and why did the private equity buyers get involved in the transaction? What were the underlying motivations of the interested parties? Ironically, it was this set of complex risks that opened the door to private equity participation. GA and TPG were able to demonstrate to Lenovo and the Chinese government that they could provide crucial assistance in navigate the financial, operational and cultural hazards of the transaction. The deal was the first of its kind. Prior to the Lenovo-IBM transaction, virtually all private equity investment in China was growth capital transactions with an average deal size of $22 million.25 Successful deals tended to be focused on exporting successful U.S. business models to China in order to access the domestic Chinese market.

In contrast, this deal was driven by

Lenovo’s interest in finding private equity partners who could “…offer expertise and experience that are expected to be valuable to the Company” in its global expansion.26 In addition, Lenovo believed that the involvement of the three private equity firms would validate their investment thesis and enhance its credibility in the global capital markets, increasing the likelihood of a successful listing on US stock exchange in the future. GA provided due diligence assistance to help Lenovo assess the IBM PC opportunity during the auction process in order to win the option of participating in a potential deal as a minority investor.27 GA had been operating in China for five years through their investment in ecommerce software and services company, Digital China, a subsidiary of Lenovo’s parent company, Legend holdings. GA helped Legend spin out Digital China helped and take it...