Analysis: IBM adjusts to harsh PC market

Companies find it's tough generating consistent profits from PCs

Perhaps it isn't quite as surprising as if Ford suddenly decided to sell its Mustang sports car brand to Hyundai. But IBM's decision to sell its PC business to China's Lenovo Group Ltd. underscores the challenges that manufacturers face in the modern PC business, even for a company synonymous with the product.

As expected, the companies announced a deal this morning in China that calls for Lenovo to pay $1.25 billion in cash and equity for IBM's PC business, and for IBM to take an 18.9% stake in Lenovo.

In terms of PC shipments, IBM has ranked a distant third among vendors worldwide for several quarters, behind Dell Inc. and Hewlett-Packard Co.. However, its ThinkPad notebooks enjoy a strong reputation among corporate customers, who are impressed by the security and reliability features built into the product family. Also, IBM's historical role in the development of the PC also gives it some extra cachet among certain customers.

With all those factors in its favor, why would IBM seek a gradual exit from the PC business? Quite simply, it's just too difficult for most companies to generate steady profits selling PCs, said Roger Kay, vice president of client computing at market research firm IDC in Framingham, Mass.

Among top-tier PC vendors, Kay said, only Dell's direct sales model and vigorous inventory management have allowed it to consistently post profits.

Components such as memory and displays are subject to wild fluctuations in price. PCs are also harder than ever to differentiate, given that most PC vendors employ many of the same contract design and manufacturing firms in China and Taiwan. Dell manufactures some PCs in the U.S., but most other vendors have given up on domestic manufacturing.

Traditional hardware companies have spent much of the past few years looking for opportunities to grow their revenue outside of a rapidly maturing PC market.

Dell and HP have developed consumer electronics divisions, but IBM has spent more time boosting its high-end server and software businesses, as well as dramatically expanding its already huge services arm with the 2002 purchase of PricewaterhouseCoopers Consulting. IBM has cut costs in its PC division by outsourcing production and dumping its hard-drive business, but financial analysts looking for better margins have long called for IBM to sell off its PC operation.

The deal with Lenovo gives IBM almost a decade's worth of cash earnings from the PC business in a single deal, Kay said. At the same time, IBM will still be able to retain its important enterprise customers that have come to rely on ThinkPads as the basic computing device for their workforces, he said. The company's primary argument against dropping PCs has been that it needs notebooks in order to provide a complete IT package to corporate customers.

For Lenovo's part, the IBM deal gives the Chinese PC-shipment leader a foothold in the lucrative U.S. and European markets. Most of the exciting growth in the PC market is taking place in emerging markets in Asia, Eastern Europe and South America, but corporate customers are attractive because products for that segment command higher margins than consumer PCs, Kay said.

Lenovo would also be acquiring the second-largest notebook PC business in China, putting it in a dominant position in its home market, Kay said.

However, IBM and Lenovo face an uphill battle trying to convince corporate customers that the ThinkPad of tomorrow will be just like the ThinkPad of today, said Stephen Baker, director of research at NPD Techworld in Reston, Va.

Maintaining the ThinkPad brand and customer base will be a challenge for Lenovo, which doesn't have experience selling products to large U.S. firms, Baker said.

IBM is taking a big risk in allowing Lenovo to keep the ThinkPad brand name, Baker said. ThinkPad customers have already demonstrated that they care more about features and product design than price, and it will be difficult for Lenovo to reassure customers that the ThinkPad's reputation will endure on its watch, he said.

If the ThinkPad evolves into just another notebook, or devolves into an inferior product, IBM will have damaged its reputation and brand among corporate customers, Baker said. This could hurt the software and servers businesses that IBM is trying to enhance.

It's too early to know exactly how enterprise ThinkPad users will be affected by the new company. But smaller businesses will likely find themselves on the receiving end of a marketing barrage from Dell and HP as those vendors try to capture accounts that IBM will not have time to service, said Sam Bhavnani, an analyst at Current Analysis Inc. in La Jolla, Calif.

Large corporate customers will require a great deal of attention from both IBM and Lenovo as they try to convince those customers that life will go on for the ThinkPad customer. These enterprises will demand to know whether they will still have IBM support in two years, or whether they can order a new batch of notebooks with their custom software image if they need to expand, Bhavnani said.

One thing all of IBM's corporate notebook customers should expect to see, several analysts agreed, is a classic cycle of FUD (fear, uncertainty and doubt) -- much of it spawned by IBM's competitors. Times of upheaval in the IT industry have been exploited by vendors that prey on user uncertainty.

While IBM appears to be kicking off the latest round of consolidation in the PC market, it will probably not be the last hardware vendor to rethink its approach to the market. Gartner Inc. recently put out a report predicting that three of the top 10 PC vendors will exit the market by 2007.

With IBM, the No. 3 PC company, and Lenovo, the No. 8 PC company, joining forces, the spotlight now switches to HP. Chairman and CEO Carly Fiorina is still having a hard time convincing analysts that the acquisition of Compaq Computer Corp. was worth the time and effort.

At HP's analyst meeting yesterday in Boston, Fiorina acknowledged that HP's board has considered a breakup in the past. If growth in the PC market stagnates in 2005, as predicted by Gartner and IDC, HP might find itself pondering the same set of options that led to the IBM-Lenovo deal.

Copyright © 2004 IDG Communications, Inc.

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