Why IBM Is Selling Its Server Business to Lenovo

The world's largest PC manufacturer, Chinese technology company Lenovo (NASDAQOTH: LNVGY  ) , will pay $2 billion in cash and $300 million in stock to acquire IBM's (NYSE: IBM  ) x86 low-end server business, also known as System X.

This is not the first time Lenovo acquired a business unit from Big Blue. In 2005, the company acquired IBM's ThinkPad line of PCs. The company eventually ended up becoming the biggest player in the PC arena. A shrinking PC industry was no impediment for Lenovo to establish a profitable PC business, helped by economies of scale and high quality standards in manufacturing. Lenovo posted a 36% hike in profits last November, but Lenovo wants more. It aims to conquer the smartphone space, and now, the low-end server market.

IBM wins
Overall, the latest acquisition seems to be a win-win situation for both Lenovo and IBM. Big Blue's low-end server business has been shrinking for a while, hurting the company's bottom line. This move also reduces IBM's dependency on hardware significantly. That's exactly what the company wants. Big Blue's new business priorities in its 2015 road map are cloud computing, Smarter Planet, business analytics, and growth markets. Moreover, between 2010 and 2013, the company spent roughly $12 billion in acquisitions, buying mainly software companies in the cloud space. 

There will always be a place for hardware
Note that although IBM is emphasizing software nowadays, the company is not retiring completely from the server world. It plans to stay in the high-end server and mainframe business, focusing on its System Z and Power lines, together with its storage systems.

In other words, Big Blue is basically selling the low-margin, high-volume segment. This is consistent with IBM's new strategy, which focuses on high-margin software sales, and using mainframe and System Z technologies as a way to cross-sell its recurrent service and profitable support contracts.

Apart from getting $2 billion in cash, IBM will have permission to continue selling System X servers as a reseller partner for Lenovo. Unlike System Z -- mainframe servers for large corporations -- IBM's System X portfolio of servers was basically targeted at mid-sized corporations, hosting companies, and clients with small cloud needs.

Lenovo wins, Hewlett-Packard loses
The recent acquisition puts Lenovo in a better position to compete against Hewlett-Packard  (NYSE: HPQ  )  and Dell in the server market.

Hewlett-Packard will now face a rival that isn't afraid of aggressive pricing to capture market share. In the third quarter of the past year, Hewlett-Packard had the largest share in the $9.5 billion low-end server market, according to IDC.

This could change dramatically in the coming quarters, because the latest acquisition is expected to move Lenovo ahead five years in its plan to expand in servers, raising its global ranking among suppliers from No. 6 to No. 3, according to Peter Hortensius, senior vice president at Lenovo. 

Final Foolish takeaway
The acquisition of IBM's low-end server business by Lenovo may be a win-win situation. IBM, which reported its seventh straight quarter of declining revenue last week, is trying to reinvent itself once more by focusing on high-growth areas, such as cloud computing and software.

The deal will also give Lenovo about 12% of the world's server market. Although the acquired business unit is barely profitable, by increasing sales volume, Lenovo could transform IBM's low-end server unit into a cash-flow machine, as the company is well-known for using an aggressive pricing strategy combined with high-quality quality control to successfully capture market share.

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