After months of waiting for approval from both U.S. and Chinese regulators, Lenovo Group (NASDAQOTH:LNVGY) is finally set to close the deal to buy International Business Machines' (NYSE:IBM) x86 server business. Lenovo's goal is to become the leading server vendor in the world, much like it did in the PC market after buying IBM's PC business 10 years ago. Hewlett-Packard (NYSE:HPQ), which lost the title of the top worldwide PC vendor to Lenovo in 2013, could suffer the same fate in the server market as well.
The winners: Lenovo and IBM
This deal, where Lenovo will pay IBM $2.1 billion for the x86 portion of its server business, benefits both Lenovo and IBM. Lenovo, a company that has grown rapidly over the past decade as it steadily conquered the PC market, will need to look beyond PCs in order to continue growing in the future. Mobile devices like smartphones and tablets are part of the company's strategy, but enterprise hardware looks to be the most promising growth driver.
Lenovo CEO Yang Yuanqing has stated that he expects the x86 server unit to generate $5 billion of revenue during its first year, along with higher margins compared to the 4% margin of Lenovo's PC business. That's a minimum of $200 million in additional operating profit, representing a nearly 20% increase compared to the most recently reported fiscal year.
Beyond the first year, Lenovo is ultimately aiming to win market share from competitors like HP and Dell, eventually becoming the top server vendor in the world. About $50 billion in servers are sold globally each year, putting Lenovo's expected market share after the IBM purchase at 10%. There's plenty of room to grow, and if Lenovo can do the same in the server market as it did in the PC market, the company's server market share could double before the end of the decade.
It may seem like IBM is getting the short end of the stick with this deal, but unloading its x86 server business fits in with the company's overall strategy. There's very little differentiation between x86 servers, which are predominantly powered by Intel chips, and this has led to the increasing commoditization of the market. IBM is not a seller of commodity products, and it's clear that the x86 server business needed to go.
IBM is keeping its other enterprise hardware units, most notably its System Z mainframes. IBM's mainframe computers remain critical to many industries, and IBM derives a significant part of its profits from software and services related to mainframes. While IBM has a huge advantage in the mainframe portion of the server market, with extremely high switching costs for many customers, it has no such advantage in the x86 server market, and dumping the commodity business frees IBM from having to compete in a market with far lower margins than the rest of its business.
The loser: HP
While there's no guarantee that Lenovo will be able to win server market share, the company's track record in the PC market should have HP very worried. HP is the leading server vendor, with a market share of around 25%, and a significant portion of the company's profits are derived from enterprise hardware. During the most recently reported quarter, about 41% of HP's operating profit came from its enterprise group, and nearly half of the revenue in this segment came from servers. In other words, a loss of server market share would not be kind to HP's bottom line.
Falling margins would also hurt HP, and while the operating margin in its enterprise group has already been declining for the past couple of years, further declines could be driven by Lenovo's aggressiveness in going after server market share. When IBM exits a business, as it did with PCs 10 years ago, there's a good chance that margins for the industry are on their way down.
HP is hoping that its Moonshot servers will create a brighter future for its server business. Moonshot servers are powered by the kinds of low-power chips typically found in phones, as opposed to traditional servers powered by high-end Intel chips. HP launched its first Moonshot servers last year, but so far they've failed to meet expectations. The first 64-bit Moonshot servers were recently announced, powered by new 64-bit ARM chips, but Intel's dominance will be a big barrier to the success of the platform. While Moonshot could potentially be something that allows HP's products to stand out, particularly important with Lenovo ready to pounce, success of the project is far from guaranteed.
Lenovo has the opportunity to greatly expand its presence in the enterprise hardware market with the purchase of IBM's x86 server business, and market leader HP stands to lose the most. Lenovo has already stolen the title of the top PC vendor in the world from HP, and now it's looking to do the same in the server market. Time will tell whether Lenovo's strategy will pay off, but HP investors certainly have something to worry about.