Lenovo and IBM: East Meets West, Big-Time

The date was April 20, 2004. The setting: the offices of Legend Holdings in
Beijing. And the event was something akin to a courtroom trial, in which the
proposed purchase of IBM's PC division by Legend subsidiary Lenovo Group hung
in the balance. The judge and jury-Legend's directors, including co-founder
Liu Chuanzhi-had gathered in a windowless conference room on the 10th floor of
company headquarters to grill Lenovo's execs and others about potential
pitfalls.

The deal's advocates faced a barrage of questions. In addition to Mary Ma,
Lenovo's chief financial officer, the lineup included people from consultant
McKinsey and investment bank Goldman Sachs. The directors' chief concern: Were
Lenovo's execs really capable of running a complex global business? The
breakthrough came after three days. The directors concluded that if Lenovo could
recruit IBM's top execs to help manage the company, this merger could succeed.
"The board felt there were positive solutions," says Liu.

Watch out Michael Dell. What began in Beijing a year ago is expected to
culminate with the closing of Lenovo's acquisition of the IBM PC division in
early May. There are huge challenges ahead for Lenovo, and Dell Inc's
dominance in the US market isn't in danger. But the new Lenovo, with $13 bn in
sales and 8% of the worldwide PC market, will boast a rare combination of
management savvy, technical expertise, low costs, and proven track record in the
developing world. As markets like China, India, and Russia become more
important, Lenovo could end up presenting Dell with its most serious competition
in years-by boxing it off where demand is growing fastest. "As the battle
shifts from the US to the rest of the world, Lenovo has the advantage,"
says analyst Martin Reynolds of researcher Gartner.

The Icon and the Upstart

Lenovo's strength is its unusual nature. Rather than sell its PC business
outright, IBM ultimately decided to keep a 13.4% stake in the combined company
and as Liu had hoped, contribute top IBM execs to help run it. In essence, IBM
outsourced its PC business to Lenovo, and Lenovo outsourced much of its
management and sales to IBM. As a result, the first major merger between an
American company and a Chinese one is creating a true blend of East and West, of
tech icon and industry upstart. The chief executive will be Stephen M Ward Jr,
the former head of IBM's PC operation. Yang Yuanqing, the former Lenovo CEO,
will be the chairman. The 30-member executive staff is split down the middle.
Headquarters will be near IBM's in New York.

The two companies complement each other neatly. Lenovo specializes in
consumer PCs and low-cost manufacturing. It dominates the PC market in China,
with a 26% share last year. IBM ranges worldwide and focuses on businesses. Its
30,000-person sales force and global network of 9,000 business partners will
help sell Lenovo PCs. "They create a formidable force against the direct
guys like Dell," says Kevin M Murai, president of Ingram Micro, the No 1
tech-products distributor.

Of course, the tech industry is littered with companies that thought they had
an edge on Dell, only to be driven into oblivion by its relentless efficiency.
The Round Rock company has garnered 18.5% of the PC market and demonstrated that
it's without peer in PCs. Hewlett-Packard Co, the second-largest player, has
lost share in recent years, to 15.4%, and is only marginally profitable. Even
IBM's PC division lost ground in the first quarter, with unit sales up just
2%, compared with 13% for Dell, according to researcher IDC. The new Lenovo
"will be good for us," says Kevin B Rollins, Dell's CEO. "We
think a lot of IBM customers will want to come to us."

But Lenovo isn't planning to out-Dell Dell. What makes Dell so successful
is the efficiency of its purely direct-sales approach and build-to-order
manufacturing. Lenovo has a very different philosophy. It will sell through
retailers, corporate resellers, the IBM sales force, and Dell's route as well.
That presents a sizable opportunity, particularly in emerging markets.
Worldwide, more than 80% of PCs are sold through retailers and other resellers.
That figure is even higher in China and other developing countries, where
consumers like to get their hands on products and frequently don't have credit
cards.

Not that Lenovo can't pinch pennies. Its labor costs are a rock-bottom $3
per desktop PC, among the lowest anywhere. That has helped drive its operating
expenses to less than 9% of revenues, half the average for the computer hardware
business and about the same as Dell's. Lenovo's expenses will rise as it
combines with the higher-cost IBM division, but it doesn't have to overtake
the big dogs to be a winner. It just needs to take market share, gain economies
of scale, and grow profitably. Lenovo's track record is persuasive. In spite
of tough competition from local rivals Tongfang and Founder, it upped its market
share in China by four percentage points, to 28%, between the first and fourth
quarters last year.

Added Muscle

The new Lenovo has to work the same magic as it combines the two operations.
Morgan Stanley projects a net profit of $221 mn, on sales of $14 bn, in fiscal
2006. That's paltry compared with Dell's expected $4 bn in profits, on $57
bn in sales, for fiscal 2006. But Lenovo may be able to squeeze out even more
costs. The company says publicly it expects to save more than $200 mn a year in
supply-chain efficiencies. Sources close to the deal say Lenovo could save
several hundred mn yearly on top of that because the company will no longer have
to pay IBM corporate expenses and may be able to get high-volume discounts from
suppliers Microsoft Corp and Intel Corp. "Potentially, there's a lot of
money on the table," says a financier close to the deal.

With its added muscle, Lenovo fully intends to change the dynamics of the PC
business. Rather than simply compete on price, the company plans to distinguish
itself through innovation. The new company starts from a good spot. IBM's
ThinkPad laptops have consistently beaten Dell to market with features such as a
built-in fingerprint reader. Lenovo is no slouch either. One of its new PCs with
easy-to-use Internet telephone service has won raves from reviewers. Declares
Yang: "We will be the PC company with the best balance between innovation
and efficiency."

The big test comes when the two organizations actually operate together. The
culture gap is huge. For instance, the Chinese don't tolerate being tardy for
meetings, while IBMers are often late. It's hard to predict when glitches will
pop up. Last December 20, when Yang, Ma, and eight other Lenovo execs landed at
John F Kennedy International Airport in New York for their first planning
meetings, nobody met them. Not good: In China, visitors are greeted and taken to
their hotels in limos. "We blew it," says Brad Hall, an IBM consultant
working on the transition. "Yuanqing brought it up at a meeting, and Steve
said, 'We'll fix that."'

Over the five months since the deal was announced, execs from both sides have
been working feverishly to get off to a fast start. Initially, to avoid
disruptions, they will operate three separate business units-China PCs, China
cell phones, and international operations, which were formerly IBM's. But they
plan to quickly integrate supply-chain operations. Ward plans to expand consumer
sales into four countries beyond China this year-though he won't name them
yet. He plans a marketing blitz to turn Lenovo into a global brand culminating
with sponsorships of the 2006 and 2008 Olympics. And he's partnering with
Intel, Microsoft, and others on PC innovation centers in Beijing and Raleigh,
NC. "The PC is ubiquitous, but purely being a commodity isn't good
enough," says Ward, 50.

This long, strange saga started with an act of quiet desperation. In the
summer of 2002, IBM's then-chief financial officer, John R Joyce, hit China in
hopes of selling the company's struggling PC business to Legend, which later
changed its name to Lenovo. But IBM's once-proud PC unit had lost nearly $400
mn the previous year. Legend execs turned up their noses.

Eighteen months later, it was a different story. Joyce returned to China and
Lenovo was hungry to become a global player in the PC business. Then CFO Ma took
her first trip to New York to talk things over with IBM negotiator Peter Lynt.
Liu had cautioned her not to fall in love with the deal, but Ma saw that IBM had
radically restructured the PC unit. Costs had been slashed. Manufacturing for
everything but the laptop line had been outsourced. "We were astonished to
see the better numbers," says Ma. She returned to China an advocate for the
deal.

Breakthroughs

Still, IBM wasn't taking any chances. It sought out private equity giant
Texas Pacific Group as an alternative bidder and the rival to put pressure on
Lenovo. "Peter would use the other bidder against us," recalls Ma.
"He said, 'If you don't do that price, you're out."'

But Lenovo was in. Ma's enthusiasm helped win over her board. A second
breakthrough came last summer during a week of top-secret talks at the luxurious
Siena Hotel in Chapel Hill, NC. After a series of meetings, Yang and IBM CEO
Samuel J "Sam" Palmisano agreed this would be more than just a simple
sale of assets. Instead, the two companies would form a strategic alliance.

While the general idea had been floating around for months, the two companies
nailed down the details to make a long-term partnership compelling for both
sides. IBM would sell Lenovo PCs through its sales force and distribution
network. IBM also would provide services and financing for Lenovo PCs-and
allow Lenovo to use the vaunted IBM brand name for five years. In turn, Lenovo,
which is still partly owned by the government's Chinese Academy of Sciences,
would help IBM gain entrée into the promising China market.

IBM ended up with two options for its PC division. At a board meeting on
October 26, Ward and IBM CFO Mark Loughridge laid out the offers from both
Lenovo and Texas Pacific. They were attractive enough that directors OK'd a
deal with either one. Ultimately, on the first weekend in December, Palmisano
accepted Lenovo's bid. The offer was higher, at $1.25 bn, and the help in
China was a substantial sweetener. Even Texas Pacific saw the logic behind
Palmisano's decision. The company, along with private equity players General
Atlantic and Newbridge Capital, later invested $350 mn in Lenovo.

Since the deal was announced, both Lenovo and IBM have been working hard to
make sure it will be a success. They've tried to be open to each other's
cultures. Yang declared English Lenovo's official language. Liu tapped Ward as
Lenovo's CEO, a position Ward considers a big honor. He recalls listening to
news of Nixon's historic visit to China on the radio when he was a 17-year-old
pumping gas at his father's Exxon station in Santa Maria, Calif. "If you
had told me then that I would lead the first-ever merger of a Chinese company
and an American company, I would have been stunned," Ward says.

Making history is messy, however. When Ward and Yang met for lunch at IBM's
Madison Avenue offices for a get-to-know-you session, Yang said that he favored
dual headquarters, in the US and China. It was a point of national pride. Ward
disagreed, saying there should be a single one, in New York. They couldn't
resolve the issue over lunch. But a couple of days later, Yang came around.
"Steve made a lot of sense," he says. "Putting the headquarters
in New York tells our global customers that we're a global company."

Now, Lenovo execs are busy moving into the fourth floor of a small office
building five miles from IBM headquarters. Seventy people will work there,
including Ward, Yang, and Ma.

Meanwhile, back in Beijing, Liu is preparing to give up command of the
company he has led for 21 years. It's a big change for someone who started the
company with $24,000 in a two-room cottage near "Swindler's Alley,"
Beijing's electronics black market, and built it into one of China's most
respected businesses. "I am quite satisfied with what I have accomplished
so far," he says. "So now I'm stepping back and letting a younger
generation lead."

As Liu bows out, a new era dawns for Lenovo. And really, for the whole
business world. If China is to make the leap from low-cost producer to global
economic giant, it will be nervy outfits like Lenovo that lead the charge.
Goodbye Swindler's Alley, hello world.

By Steve Hamm in New York With Dexter Roberts in Beijing and Louise Lee in
Austin, Tex. in New York in BusinessWeek. Copyright 2005 by The McGrraw-Hill
Companies, Inc