Business Process Transformation for Chinese-American Joint Venture Outsourcing after Divestiture of Manufacturing Operations: IBM’s Services Agreement with Lenovo for Personal Computers — Financial, HR, Legal and Regulatory Issues in International M&A

October 9, 2009 by

On December 7, 2004, IBM announced a definitive agreement for the transfer of its Personal Computer Division (“PCD”) to Lenovo Group Limited (formerly known as Legend), a Chinese state-owned enterprise. The transaction and resulting ongoing commercial relationship between IBM and Lenovo herald a new era in post-sale support following divestiture of product manufacturing business.

In divestitures generally, sensitive issues of post-transfer marketing, trademark goodwill and customer support need to be addressed. In the divestiture of a global business to a regional buyer, particularly a foreign government-owned buyer, raises issues of political review of the technology, finance and other aspects of the transaction.

The IBM-Lenovo transaction converts an American wholly-owned product manufacturing, marketing, financing, selling and servicing operation that had been fully integrated with other products and services into a joint venture controlled by a Chinese “buyer.” The approach differs from a straight sale in many respects, particularly in the degree of the “seller’s” ongoing involvement in the operations of the divested operation.

As a transformation of Lenovo’s business into a global model, the transaction will extend the management by non-Chinese for a Chinese-owned business. The deal continues the change in IBM’s brand from product-focused “THINK” to service-focused “On Demand.”

Business managers, chief executives and marketing officers and lawyers and investment bankers advising on, or participating in strategic mergers and acquisitions, can benefit from the lessons of the transaction.

Overview of Deal Structure.

Initial reports identified the deal as a sale with a value at between $1 billion and $2 billion, for a division that analysts suggest generated $10 billion in annual revenues with roughly break-even profitability. The deal structure focused on enabling Lenovo to retain IBM customers and prospective customers, thereby maximizing the value of the transfer during a limited period. IBM will lend its trademark, marketing and customer support, technical assistance, financing and access to IBM’s sales channels outside of China. IBM’s public statements have not identified the transaction as a sale, but rather as an acquisition by Lenovo. The transaction is expected to be completed in the second quarter of 2005.

Ongoing Business Relationships: IBM Commitments to Lenovo
Branding License to use IBM “THINK” logo and brand for up to 5 years IBM Corporation
Sales and Marketing Marketing support and demand generation for Lenovo products [probably at least for the duration of the license to logo and brand] IBM Client Sales
Financing “Channel” financing to allow distributors and dealers to purchase inventory for resale to customers; lease financing to end-user customers IBM Global Financing
Service and Support Maintenance, warranty support and related services IBM Global Services
Products as Solutions (Systems Integration) PC’s for customer solutions, strategic outsourcing IBM End-to-End Solutions
Transitional Services Information technology support and other services for a “limited time” IBM Operations

Source: IBM; Bierce & Kenerson, P.C.; Outsourcing Law Global LLC.

Financial Structure.

The valuation of a money-losing operation requires a buyer and seller to confront the uncertainties of the future revenue stream, operating cost structure and economic, commercial and regulatory risks of the business. In this case, much of the value of the PCD as a going concern depends on IBM’s willingness and ability to support the growth and development of organizational infrastructures — multinational management teams and global sales operations — that Lenovo simply did not have.

Absence of an Earn-out Pricing Clause.
As a buyer, Lenovo would normally be willing to pay more for a greater revenue stream, suggesting an “earn-out” agreement that values the PCD based on a measure of post-closing revenue. The announced deal structure does not include an “earn-out” pricing adjustment, since both the cash portion and the Lenovo common stock portion are fixed. However, there could be some “earn-out” adjustment since the amount of “projected” PCD liabilities assumed by Lenovo could be determined based on some formula relating to actual sales. Such an earn-out would be highly unlikely, given the mutual desire for certainty in pricing, and the fact that Lenovo’s ability to generate business that might affect the valuation might be too far distant in the uncertain future to justify using an earn-out.

Ongoing Revenue Stream.
Given Lenovo’s dependency on IBM for sales generation and customer support, as well as financing of sales, IBM obtains ongoing revenues allocable to these activities under the agreement or related agreements that set forth the pricing and terms of payment for all such essential services.

Entree into China.
By providing ongoing IBM commitments and support for Lenovo’s operations, IBM increases its credibility and generates possible new Chinese customers, including State-owned enterprises. The IBM PCD already included a Chinese 80%-IBM-owned subsidiary, International Information Products (Shenzhen) Company Limited, established on February 3, 1994, as a Chinese-Foreign equity joint venture manufacturing and selling personal computers in China. (This Chinese joint venture is owned by a Dutch company, IBM Far East Holdings B.V., an indirect subsidiary of IBM.)

Financial Impact on IBM
Price Cash at closing US$650 million
Equity (18.9%) of Lenovo Group common stock up to US$600 million in value (valuation formula not disclosed)
Liabilities assumed by Lenovo estimated US$500 million
TOTAL estimated US$1.75 billion
Pre-Tax Profit for IBM estimated US$900 million to US$1.2 billion
Benefits Short-term capital gain in second quarter 2005
Long-term reduce volatility of top-line revenues and improved profit margins
create a strong contender for PC business with ongoing service revenues from IBM including integration with IBM’s core services business
Business Strategy accelerate globalization and transformation of IBM’s global business model

Source: IBM; Bierce & Kenerson, P.C.; Outsourcing Law Global LLC.

Financial Benefits to Lenovo.

The IBM support for marketing, sales, customer service, technical assistance and financing will provide several benefits to Lenovo:

  • Costs:
    Reduced the infrastructure and services costs.
  • Technology:
    Transfer of technology, know-how and management practices in every element of support so that Lenovo may reach the “IBM Standard” level of support consistent with the IBM brand and goodwill worldwide.   Lenovo needs this transfer of skills to compete in a global market against Dell and Hewlett-Packard in the personal computer industry.
  • National Champion:
    A local “national champion” will be able to compete in the Chinese home market, which is now reported to be the second largest in the world after the United States.

Strategic Financial Benefits to IBM.

IBM will reap financial benefits in converting deepening losses into opportunities for new fees and ongoing business in services, financing and in capital gains.

  • Ending a Liquidity Drain.
    As of December 2004, IBM’s PCD had been an albatross.  Accumulated negative position in shareholder equity had ballooned to $991 million at the end of 2003, compared to negative $628 million at the end of 2002 and negative $266 million at the end of 2001.  In an SEC filing, IBM admitted: “The Business has a history of recurring losses, negative working capital and an accumulated deficit. The ability to settle obligations as they come due is dependent on IBM funding the operations on an ongoing basis.”
  • Avoiding Further Major Capital Investment.
    The transaction will allow IBM to escape significant new capital investment expenses.  Such expenses include any new capital investment (such as technological or physical obsolescence) in marginally productive assets.  IBM avoids expenses that will have to be paid to comply with emerging environmental protection and conservation rules.   In particular, the PC business must comply with two directives of the European Commission that require member states of the EU to meet certain targets for collection, re-use and recovery of waste electrical and electronic equipment.

    • Waste Electrical and Electronic Equipment Recycling Directive.
      In February 2003, the EU published the Waste Electrical and Electronic Equipment directive, or WEEE (Directive 2002/96/EC, which was amended in December 2003 by Directive 2003/108/EC). The WEEE directive, regulates the collection, re-use and recycling of waste from many electrical and electronic products.  The WEEE directive must be implemented by August 13, 2005.  Under the WEEE directive, equipment producers are required to finance the collection, recovery and disposal of electronic scrap.   As of the end of 2004, most member states had not yet issued their implementation requirements.  On this basis, IBM escaped having to accrue any foreseeable capital expenditures to comply with the directive, and Lenovo assumes a regulatory risk.
    • Restrictions of Hazardous Substances Directive.
      This directive (the ” RoHS Directive”) (Directive 2002/95/EC), bans the use of certain hazardous materials in electric and electrical equipment.  Under the RoHS directive, manufacturers have a transition period until July 1, 2006 to phase out the use of certain hazardous materials from its equipment.
  • No Consolidation with IBM’s Financial Statements.
    If recurring losses were a possible risk of the PCD after the sale, IBM would want no financial consolidation after the sale.  For IBM, the transaction had to be structured to avoid having its interest in Lenovo after the “sale” be consolidated and incorporated into IBM’s financial statements and tax returns as an affiliate (if Lenovo or the Lenovo entity were a domestic corporation) under Section 1361 of the Internal Revenue Code of 1986, as amended.   For both accounting and tax purposes, the threshold is 20%.   IBM’s 18.9% ownership will easily pass this hurdle.  The 1.1% difference provides a margin to argue against any potential claim by the IRS that inter-company transactions are not at arm’s length, therefore constitute some form of disguised equity under Section 482, and thereby consolidation should apply for income tax purposes.
  • Steady Profit Streams.
    IBM gets the prospect of steady and profitable revenue streams from technical support and financing, both of which IBM provides in the ordinary course to its own customers.
  • A New Governmental Customer.
    IBM may get a new customer (and, indeed, a lightning rod to attract other customers) that is owned partially by the Chinese government, thereby expanding IBM’s reach for its business consulting practice.
  • Repositioning of Core Business.
    IBM gets to reposition its management focus onto its core business of consulting services in business management,  business process operations and information technology infrastructures and on selling and maintaining large computers that power large corporate networks and the Internet.

Constituencies Needed for Lenovo’s Success.

Lenovo needs to satisfy not only the U.S. and European regulators, but also its employees, customers, suppliers and investors. Lenovo has shown substantial interest in adopting Western business practice, though it has a long way to go.

  • Employees – Global Model for Human Resources Skill Set Development.
    Lenovo will retain American senior executives, who will be located in New York next to IBM’s offices.   International growth in sales and marketing will depend on non-Chinese executives.
  • Employees – Retention, Compensation and Incentives.
    Lenovo has adopted stock option plan for its employees.  This will help align with the 19,000 employees of the IBM PCD who will be transferred to the new Lenovo PCD operations.  Since the deal thrusts Lenovo into the  local and international spotlight for stock options and stock purchase plans for employees.   The Chinese Government and other Chinese enterprises will thus have a model for such human resources incentives.

    • Stock Option Plan.
      Under IBM’s stock option plans, stock options are granted to employees at an exercise price equal to the fair market value of IBM stock at the date of grant. Generally, options vest 25 percent per year, are fully vested four years from the grant date and have a term of ten years.
    • Stock Purchase Plan.
      The PCD Business’ employees and IBM employees that provide direct support to the PCD Business participate in the IBM Employees Stock Purchase Plan (ESPP). ” The ESPP enables substantially all regular employees of the Business to purchase full or fractional shares of IBM common stock through payroll deductions of up to 10 percent of eligible compensation. The ESPP provides for semi-annual offerings, and continues as long as shares remain available under the ESPP, unless terminated earlier at the discretion of the IBM Board of Directors. The share price paid by an employee equals the lesser of 85 percent of the average market price of IBM common stock on the first business day of each offering period or 85 percent of the average market price on the last business day of each pay period. Individual ESPP participants are restricted from purchasing more than $25,000 of IBM common stock in one calendar year or 1,000 shares in an offering period.”  [per IBM].
    • Stock-Based Compensation.
      IBM’s PCD Business’ employees participate in IBM’s various incentive award plans.  The IBM PCD Business ” records expense for grants of employee stock-based compensation awards equal to the excess of the market price of the underlying IBM shares at the date of grant over the exercise price of the stock-related award, if any (known as the intrinsic value). Generally, all employee stock options are issued with an exercise price equal to or greater than the market price of the underlying shares at grant date and therefore, no compensation expense is recorded. In addition, no compensation expense is recorded for purchases of IBM stock made by the Business’ employees under the IBM Employee Stock Purchase Program (ESPP) in accordance with APB No. 25. Additionally, the intrinsic value of restricted stock units and certain other stock-based awards issued to employees as of the date of grant is amortized to compensation expense over the vesting period. To the extent there are performance criteria that could result in an employee receiving more or less (including zero) IBM shares than the number of units granted, the unamortized compensation is marked to market during the performance period based upon the intrinsic value at the end of each quarter.”  [per IBM].
    • Retirement-Related Benefits.
      The current IBM PCD employees participate in certain “defined benefit” pension plans, certain “defined contribution” benefit plans and certain non-pension post-retirement benefit plans.  Lenovo will likely adopt similar plans.
    • Incentives.
      For the American senior executives retained to implement Lenovo’s globalization strategy, one can anticipate the same style of executive compensation that IBM has adopted for its senior executives and members of its board of directors.   Special sign-on incentives and incentive-based compensation may be available.  The public announcements are silent on this aspect.
  • Listing on Hong Kong Stock Exchange.
    Lenovo is listed on the Hong Kong stock exchange.  This listing. has made it a model, among Chinese companies, for corporate governance, privatization and shareholder rights.

Management Control.

Lenovo would not be able to succeed without experienced international managers.  IBM’s senior PCD managers will continue working for the Lenovo PCD.  Sales and marketing management will be headed in New York, not China.

Production Locations.

As a new model, the “future Lenovo” follows the “near shore” or “right shore” structure of having sales and marketing processes close to the customer, while production can be partially or totally offshore.   Given the success of the Dell model for custom-made personal computers, one may even assume that Lenovo will engage in some onshore assembly, perhaps in Mexico.

Impact on Outsourced Production: Sanmina SCI.

In January 2002, IBM’s PCD Business had already sold certain of its North American and European desktop personal computer manufacturing operations to Sanmina SCI.  Along with that sale, IBM’s PCD Business had entered into a three year outsourcing agreement with Sanmina SCI to manufacture personal computers for the PCD Business.  As a result of this transaction, IBM sold fixed assets and inventory, and later sold to Sanmina SCI certain of its mobile personal computer manufacturing operations processes to Sanmina SCI.

  • Opportunities and Risk for Sanmina SCI as Contract Manufacturer.
    As a result of the Lenovo transaction, Sanmina SCI is at risk of losing a renewal of the IBM PC manufacturing contract, which might be terminated early.  Alternatively, Sanmina SCI might help Lenovo with a new outsourcing for manufacturing, perhaps for another five years (particularly during the term of the license for the IBM “Think” trademark and logo).
  • Flexibility.
    IBM’s outsourcing of production to Sanmina SCI allowed IBM to avoid further capital expenses beginning in January 2002.

Trademark Goodwill.

A five-year trademark license is reasonable in divestitures of consumer-oriented businesses.   In this case, the PCD’s customers are principally individuals who either pay for the PC’s or have decision authority for corporate procurement departments.

To preserve IBM’s goodwill, IBM will certainly enforce the high standards of production and service that the IBM name has come to be associated with in the minds of the technology consumer.   As part of the transactional documents, the trademark agreement may give IBM extensive rights to oversee virtually all phases of Lenovo’s operations “in order to ensure quality” and goodwill.

Risks for Lenovo.

By purchasing from IBM, Lenovo assumed many new significant risks.

  • Lack of Leadership.
    The sale is an act of faith that Lenovo can learn to compete globally.   At the time of sale, Lenovo was neither a technology leader (like IBM or Apple Computer Inc.) nor a cost-efficient producer (like Dell Inc.).   Immediately before the sale, Lenovo was portrayed as  a company in transition, losing market share to foreign competitors.
  • Restructuring and Retrenchment.
    For a few years, Lenovo attempted to diversify into technology services and contract manufacturing.  This diversification attempt apparently failed, resulting in layoffs and retrenchment.  Lenovo’s ability to absorb the IBM personal computer manufacturing division and to develop the expertise in all aspects of product support and customer support presents a significant challenge.  The challenge includes the possibility that pursuing a global market strategy could weaken Lenovo’s focus on its home market, thereby putting the entire company at risk.
  • Geographical Concentration.
    As of December 2004, Lenovo’s business was concentrated in China, with only 3% of sales coming from foreign sources.
  • Limited Global Supply Chain.
    Lenovo’s dedication of its indigenous products to its indigenous market will result in serious logistical challenges.  It will be highly dependent on IBM for process management and transitioning over time.  If anything, the duration of IBM’s commitments to support product delivery, installation, repairs and after-sales customer support will probably continue for a long time.   While Dell already outsources many of these functions, Dell has more experience in selecting and managing such service providers across many countries.  Lenovo will have to learn not only to manage IBM (to avoid discontinuity), but also to develop and manage a global network of local logistics and support providers.  Lenovo’s purchase will include many such personnel and facilities, but the process management will require a significant learning curve.  Customers could be adversely affected.
  • Innovation by Competitors.
    Lenovo’s growth in personal computers was based on cheap, easy to use basic computers.   This might have been a strength from IBM’s viewpoint, since a strong Lenovo would not likely challenge IBM at the higher end of the computer manufacturing and infrastructure support business that IBM has defined as its sweet spot.  Lenovo’s innovation is modest: using lower cost semiconductor chips from Advanced Micro Devices instead of from Intel.
  • High Cost Structure.
    Lenovo faces keen cost pressure from Dell, which manufactures computers in China and Japan.
  • High Inventory Levels and Impact on Profitability.
    Lenovo has not yet mastered the “just-in-time” method of manufacturing.   As a result, its “days of  inventory” of unsold computers is substantially higher than for its competitors such as Dell and HP.  According to a Wall Street Journal article, Dell has a 4-day rate, compared to Lenovo’s 27 days of inventory.   Such inventory levels create risks of non-sale or of sale at depressed prices, increased incentives, price protection for wholesale customers, promotions and other volume-based discounts, as competition drives prices down in a constant spiral.
  • Cultural Challenges for Chinese Enterprises in Joint Ventures with Western Enterprises.
    The record of Chinese companies trying to acquire control of Western enterprises by a joint venture is short and challenged.
  • Historical Failures of Acquisitions in the Personal Computer Market.
    Lenovo’s venture with IBM epitomizes an optimistic view about the feasibility of sustaining global market share in the personal computer market, as PC’s have become a low-priced commodity.    NEC, Acer Group and Samsung Electronics  Co. have all lost hundreds of millions in wasted investment in personal computers manufacturers such as Packard Bell Electronics Inc. (NEC), AST Research, Inc. (Samsung) and Texas Instruments Inc.’s PC unit (Acer).
  • High Mortality Rate in the PC Industry.
    Since IBM defined the PC industry in 1981 with its signature personal computer, many market entrants have come and gone.   Brand-name high volume computer manufacturing has become a capital-intensive business.   For both Lenovo and, as a major shareholder in Lenovo, IBM, the risk of mortality is significant.   However, IBM’s continuing involvement in marketing and tech support after the transfer will mitigate this risk for both parties.

Regulatory Reviews and Other Notices as Conditions to Closing.

Prior to final closing, the deal requires regulatory reviews and notices to employees.

  • Antitrust Review.
    The size of the transaction requires notification to the Department of Justice and the Federal Trade Commission for antitrust review under the Hart-Scott-Rodino Act (“HSR”).   In case of a complete divestiture to a new entrant that previously had a negligible market share in the U.S. consumer market, such review will be perfunctory.   A similar review under the European Union competition laws is likely to be perfunctory.
  • Political Review of Foreign Investment in United States.
    Under the Exon-Florio amendment to the Defense Production Act of 1950, foreign direct investment in the United States is subject to a review by the Committee on Foreign Investment in the United States.

    • Historical Transfer of Information Technology to Foreign Owners.
      IBM’s prior sale of its hard-disk manufacturing facility to Hitachi was not opposed for national security reasons.
    • Outcome of Review.
      Since the Lenovo-IBM transaction will not change the location where the PC’s are built, there are strong domestic competitors such as Dell and Hewlett-Packard and “white” [no-name brand] manufacturers using commodity components, this CFIUS review should also be perfunctory.
  • Employment Rights.
    Labor laws do not prevent mergers, acquisitions, divestitures, joint ventures or asset transfers that include operating facilities.   In general, employment laws in many countries require that the selling employer give timely advance notice and meet with representatives of the workers designated by trade unions, works councils and/or by law.   Such laws generally require a substantial advance notice.

    • United States.
      In the United States, the Worker Adjustment and Retraining Act (the “WARN” Act) gives employees in units of over 100 employees a right to a 60-day warning of a plant closure or mass layoff.   Failure to warn carries only the penalty of a duty to pay wages for 60 days from actual notice, whether or not the notice occurs before the transaction is completed. In this case, the announcement on December 7, 2004 did not focus on any WARN Act notice.   However, as the deal unfolds, certain employees could be subject to such a notice.   To the extent any employees were given notice on December 7, 2004 of any plant closings or mass layoffs, a deal closing could occur on or about February 7, 2005 without a WARN violation.
    • Europe.
      In Europe, consultations with local labor representatives, works councils and co-management directors are required  under the European “acquired rights” directive and implementing legislation.
    • China.
      Similar consultations may be necessary for the employees of the Shenzhen production facility that is owned by an IBM-controlled joint venture.
  • Agreements with Third Parties.
    A merger, acquisition or divestiture is a watershed event in business relationship of a company to its business relationships.

    • Intellectual Property.
      In the field of intellectual property rights (“IPR”), third parties who have licensed their rights to the seller may have a contractual or statutory right to prohibit the buyer (here, Lenovo) from using such IPR.
    • Services.
      Service agreements that support a line of business will need to be continued or amended.   Transfer of the operations to a new enterprise may trigger a termination of such contracts.   Ownership of less than 20% of the new business generally results in loss of sufficient control by the “selling” company such that third-party service providers may invoke any termination rights in their agreements.   NOTE: Many outsourcing agreements might not include any such right of termination by the service provider for change of control of the enterprise customer (here, IBM, to the extent that it is a recipient of third-party services under such an outsourcing agreement).
    • Loans and Financing Arrangements.
      Divestiture of assets may trigger an event of default under applicable bank loans, trust agreements for securitization of accounts receivable, shareholder agreements, credit and funding agreements, currency swap and hedging agreements and other financial arrangements.  In this case, the particular segment being divested did not generate any material profits, and the $1.5 billion price tag might not even have been “material” for accounting or financial purposes.
    • Lease Agreements.
      Landlords typically include a “change of control” provision that allows the landlord to terminate the lease upon a change of control.   However, depending on lease negotiations, the tenants (such as IBM) typically require continuation of the lease if certain financial and operating conditions are met that give adequate assurance to the landlord of the financial strength of the new venture.
  • Conveyancing.
    Under property law, the transfer of assets from one entity to another runs some typical negligible risks.  If the assets are not well identified, a post-closing assignment may be required when they are discovered.   For a business process-driven technology company, any lack of inventory records would appear a remote possibility, but prudent lawyers always require a “further assurance” clause to enable rectification of any omissions in the conveyancing of the seller’s owned assets at closing.
  • Post-Transfer Services and Support by the Seller.
    Lenovo would not have been able to expand its markets to a global scope if IBM had not agreed to provide post-transfer services and support operations to Lenovo.   In some divestitures and spin-offs, such post-closing support is merely a short-term lifeline at high cost and without meaningful assurances of quality, service levels, financial accountability or other protections for the service recipient (the spun-off or sold line of business).  In this case, IBM’s 18.9% ownership interest in a restructured Lenovo gave the seller a long-term financial interest in assuring the best possible quality for transitional post-transfer services and support.

The New Global Paradigm.

Most divestitures involve very little ongoing commitment by the seller.    In this case, IBM will be partnering with its buyer, and its buyer’s primary shareholder (the Chinese Government), to implement “business process transformation” on a global basis for Lenovo.

IBM’s exit from PC manufacturing requires an extensive and long-term commitment to the success of Lenovo as “buyer.”  By choosing a Chinese partner, IBM elected not to sell its assets to a competitor for a low price or that might result in loss of goodwill, as the HP acquisition of Compaq did.

For the venture to succeed, IBM and Lenovo must shape a new Chinese-American partnership that may serve as a model for foreign acquisitions of American enterprises.  In an emerging global business paradigm, the Lenovo-IBM partnership involves a foreign-based manufacturing capability linked to American-based marketing and business management.

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