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Lenovo Is Aiming to Disrupt the Server Market

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Lenovo (NASDAQOTH: LNVGY  ) surpassed Hewlett-Packard (NYSE: HPQ  ) in 2013 to become the world's largest PC manufacturer, and the Chinese company is now looking to do the same in the server market. Lenovo's recent acquisition of IBM's (NYSE: IBM  ) x86 server operations  will give the company an instant 13.9% share of the global server market, pending regulatory approval. If Lenovo's track record is any indication, the server market is set to be disrupted in a big way.

Lenovo's server potential
Lenovo will pay $2.3 billion for IBM's x86 server business, adding $4.7 billion in annual revenue. IBM has long been transitioning away from hardware, focusing instead on higher-margin software and services; this sale is in line with that strategy. IBM's hardware business has been struggling as of late, with the systems and technology segment recording a pre-tax loss of more than $500 million in 2013 (a drop of $1.7 billion compared to 2012). Disposing of the lower-end x86 server business, which faces direct competition from HP, Dell, and others, allows IBM to exit an increasingly commoditized market.

Lenovo faces the challenge of taking IBM's unprofitable x86 server business and transforming it in the same way it transformed IBM's PC business over the past decade. The market for x86 servers is expected to grow by 4% per year, and China is expected to account for around 20% of global x86 server volume by 2017 . The rise in demand from China is good news for Lenovo, because it's clear from the company's PC business that it has a big advantage in that country.

Lenovo has an 18.5% share of the PC market globally, but in China the company commands a staggering 37.9% of the market. China is also by far the company's most profitable market, with Lenovo's PC operating margin reaching 7.1% in the most recent quarter. Lenovo's overall operating margin was a far lower 3.1%.

Lenovo has the opportunity to leverage IBM's server business and become the leading server provider in China, along with growing its presence in other growth markets like Brazil and India. HP currently controls around 31% of the global x86 server market. Given the higher margins of the server industry, at least compared to PCs, Lenovo can steal market share by being aggressive on price.

In the most recent quarter, HP's enterprise group, which is responsible for servers, achieved a 14.4% operating margin . This includes products other than x86 servers, but it's clear that these enterprise products carry a far higher potential for profit than PCs. If Lenovo can achieve the same operating margin in its server business as it has in its China PC business, then even with just a 13.9% share of the global x86 server market the company would add about $330 million in pre-tax profit. With Lenovo on pace to earn around $1 billion in pre-tax profit in the current fiscal year, that's a 33% increase achieved by simply returning its acquisition to profitability.

If Lenovo can grow the server business and become the market leader, much like it has with PCs, then servers could eventually contribute as much as PCs to Lenovo's bottom line. Lenovo's strength in China cannot be overstated, and though gaining share in countries like the United States will be far more difficult given security concerns about Chinese technology companies, emerging markets like Brazil and India should be more receptive.

Lenovo's dominant market share and exceptional profits in its Chinese PC business suggests that the company has a good chance of being able to repeat that feat with x86 servers. It may take a few years for Lenovo to turn the IBM unit around, but the long-term potential is significant.

The bottom line
Lenovo has turned IBM's former PC business into the largest PC supplier in the world, and the company is now looking to do the same with servers. Earnings may take a hit in the short-term as the unit is integrated, but Lenovo's track record bodes well for its enterprise ambitions in the long-term.

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