Are Lenovo and IBM Finally Close to Another Deal?

It has taken a long time, but Lenovo (NASDAQOTH: LNVGY  ) and IBM (NYSE: IBM  ) may be about to finally strike a bargain for IBM's x86 server business. Lenovo has openly acknowledged its interest in this business, but the companies have been at odds on deal terms. With ongoing share loss in the server business and a desire to reallocate capital to higher-returning businesses like software and services, IBM would do well to close this deal.

The good news for Lenovo is that it can do well with or without IBM's server business. The company has built the No. 1 PC business in the world and has already grown its tablet and smartphone business to be No. 4 in terms of market share, without aggressively targeting the U.S. Lenovo looks meaningfully undervalued, and sealing a deal with IBM would only help matters.

More than just talk this time?
Lenovo and IBM have been dancing around the issue of IBM's low-end x86 server business for some time, with Lenovo openly acknowledging in the past that it would like to acquire this business and use it to grow its own enterprise business. Supposedly, the companies were close to a deal last year, but talks broke down with the companies still $1.4 billion apart on the price. 

Since then, conditions in the x86 server business have deteriorated for IBM. The company has not been reinvesting in this business and its share, according to Gartner, has dropped by over six points since 2011. With System X sales down another 16% in the fourth quarter of 2013, things aren't getting any better at IBM, and the company continues to lose ground to Dell and Hewlett-Packard.

Now, it seems that both companies may be trying again. Lenovo issued a statement to the Hong Kong Stock Exchange noting that it was in talks for a potential acquisition, and IBM's x86 server business is the most likely candidate. If the rumors are true, the price for the business may end up in the range of $2.5 billion-$3 billion -- at least $500 million lower than the supposed low end of Lenovo's offer last year.

Will Lenovo spin gold out of IBM's straw?
Readers may remember that Lenovo bought IBM's PC business in 2005, and Lenovo has leveraged that acquisition to become a significant player in the global PC market. Even now, Lenovo's share of the U.S. commercial market is meaningfully larger than its overall U.S. share (by about three percentage points).

Lenovo should be able to do the same with the IBM server business. As this hardware business offers sub-optimal returns on capital, relative to IBM's other businesses, management has been making the very reasonable decision to under-invest in it, which has only exacerbated the share loss problem. Lenovo's business model is based around much lower margin assumptions, though, and Lenovo can use that to generate better returns on (and from) this business. In other words, it not only makes sense for IBM to jettison this business, but it also makes sense for Lenovo to acquire it.

At some point, though, the underinvestment in IBM's x86 business is going to reach a critical point. Clearly, IBM has been holding out for the best return possible, but Lenovo won't buy the business if it's no longer viable. At this point, though, Lenovo can still leverage IBM's server business across its existing enterprise business (particularly in China) and drive a market share recovery.

A "nice to have," not a "must have"
Lenovo could see 12%-20% earnings accretion three years after buying IBM's server business. Even without the deal, though, Lenovo has a lot going for it. The company has emerged as the No. 1 PC share-holder in the world and continues to gain even more share in the U.S.

Lenovo is also doing well with it's "PC+" strategy, following up on its PC success with new smartphones and tablets. With only a token presence in the U.S., Lenovo has the fourth-largest smartphone business in the world (behind Samsung, Apple, and Huawei) and the fourth-largest tablet business as well (behind Apple, Samsung, and ASUS). Thus far, Lenovo has focused on establishing a strong presence in emerging markets like Brazil, Russia, India, and Indonesia, but has also, reportedly, considered using M&A to accelerate its growth in the U.S.

Without IBM's server business, expect mid single-digit revenue growth from Lenovo and slightly higher free cash flow growth. Even at an elevated discount rate, that supports a fair value above $31 today.

The bottom line
Lenovo has been building its own server business (holding about 6% share in China), but finally sealing the deal for IBM's unit would be a big step forward. At a price below $3 billion, Lenovo will have a major win. At a price below $4 billion, Lenovo will still have a worthwhile and accretive transaction. However, Lenovo may find it challenging to manage a dual focus on growing its enterprise and consumer-oriented businesses. This is a good problem to have, and I believe Lenovo remains an undervalued share-gaining play in the global PC and mobile device market. 

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