Outsourcing after Divestiture of Manufacturing Operations: IBM’s Services Agreement with Lenovo for Personal Computers
October 9, 2009 by Bierce & Kenerson, P.C.
In early December 2004, IBM’s announced sale of its personal computer division to Lenovo Group Ltd. (formerly known as Legend), a Chinese state-owned enterprise, heralds a new era in post-sale support. Sensitive issues of management control, marketing, trademark goodwill and customer support need to be addressed on cases of divestiture. The new model breaks ground in the degree of the “seller’s” ongoing involvement in the operations of the divested operation. Mergers and acquisitions advisors, chief executives and marketing officers can benefit from the lessons of the transaction.
Deal Structure.
Initial reports identified the deal as a sale with a value at between $1 billion and $2 billlion, 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.
Benefits to Lenovo.
The IBM support for marketing, sales, customer service, technical assistance and financing will provide several benefits to Lenovo:
- Reduced the infrastructure and services costs.
- 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.
- 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.
Benefits to IBM.
IBM will reap financial benefits in fees and ongoing business:
- No Consolidation with IBM’s Financial Statements.
Consolidation of a subsidiary’s financial statements and income tax reporting could 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 intercompany 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. - Opportunities and Advantages.
Lenovo has shown substantial interest in adopting Western business practice, though it has a long way to go. - Employee Retention and Incentives.
Lenovo has adopted stock option plan for its employees. - 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.
- Steady and profitable revenue streams from technical support and financing, both of which IBM provides in the ordinary course to its own customers.
- Creation of 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.
- 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.
- This repositioning allows IBM to reduce its capital investment in marginally productive assets. While IBM’s financial statements do not segregate profitability of personal computers as part of its personal systems group that incldes computerized cash registers and point-of-sale computers used in retail sales.
Management Control.
Trademark Goodwill.
Ongoing Support after the “Sale.”
Comments. The sale of IBM’s disk drive manufacturing process to Hitachi set a standard for post-divestiture support.
Risks of the Deal.
By selling to Lenovo, IBM took a number of 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 possibliity 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.
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 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. - 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.
Depending on the deal structure, the transaction must be notified to U.S. authorities in charge of identifying and monitoring foreign investments in the United States. Such notifications raise questions of whether any economic sectors that are sensitive for national security or public policy will be adversely affected. Again, since the Lenovo-IBM transaction will not change the location where the PC’s are built and there are strong competitors such as Dell and Hewlett-Packard, this 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. 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. - 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.
Post-script: As of July 2005, the deal has received all U.S. governmental approvals.