Wall Street Journal - Has Lenovo Group Really Spun Gold Out of IBM's Chaff?


Has Lenovo Group Really Spun Gold Out of IBM's Chaff? By Evan Ramstad

LENOVO GROUP LTD. appears to have turned around IBM's old PC division faster than a computer can reboot. Maybe the timing has something to do with it.

In April, its last month as a unit of International Business Machines Corp., the personal-computer operation recorded a pretax loss of $149 million. Lenovo Group took over the business in May, and it posted an operating profit of about $33 million for May and June combined.

The turnabout, revealed in Lenovo's earnings this month, sparked an 11% jump in Lenovo shares on the Hong Kong Stock Exchange on Aug. 11 and prompted several financial analysts to upgrade their view on the stock. The shares closed at HK$3.10, or about 40 U.S. cents, each yesterday, off two Hong Kong cents. At first glance, freeing the PC division from IBM seems to have worked wonders for its profitability and vindicated the acquisition. Lenovo made a splash late last year as a Chinese company little known outside Asia cutting a high-profile deal with a U.S. icon.

At the time, however, the computing industry questioned how Lenovo would revive a PC operation that posted a long string of losses under IBM.

Headlines to the contrary, that question has yet to be resolved, and some analysts caution investors not to overlook a crucial data bite: Results from the slowest sales month of the quarter fell to IBM rather than Lenovo. The first month of every quarter typically has produced the least revenue for the division. Lenovo executives gave no guidance about the sustainability of the turnaround when they reported earnings Aug. 10, citing Hong Kong exchange rules restricting the discussion of expectations.

Mary Ma, Lenovo's chief financial officer, notes the timing issue -- but also ticks off other reasons for the operation's swing to profit, including freedom from IBM expenses, the new ability to sell PCs to other units of IBM above cost and the shedding of warranty liabilities, which were kept by IBM. "The number we have is a real number -- a true number of an independent commercial entity doing business," Ms. Ma says.

Still, the factors cited by Ms. Ma can't explain the breadth of the improvement without bringing the timing issue back into play. For example, being able to sell PCs to IBM, the PC operation's largest customer, for a profit rather than at cost would have added at most about $4 million combined for May and June, based on a back-of-the-envelope estimate of $80 million in sales to IBM and a 5% profit margin.

In its earnings report, Lenovo also announced $10 million in cost savings from supply-chain efficiencies. Analyst Matthew Wilkins at iSuppli Corp. in El Segundo, Calif., estimates that Intel Corp., for instance, has cut the cost of microprocessors by 1% for the former IBM division. When the unit was part of IBM, he says, it received less-favorable pricing because IBM has a semiconductor division that competes with Intel. Ms. Ma says the company tries to build closer relationships with suppliers, but she declines to discuss specific pricing.

She also cautions that neither managers nor investors can directly compare "before" and "after" results in the wake of the PC-unit purchase because of accounting differences in the U.S., where the IBM unit was based, and Hong Kong, where Lenovo's stock is traded. (Lenovo now is based in Purchase, N.Y., but it derives most of its revenue outside the U.S.) For instance, Lenovo records revenue more conservatively than did the IBM unit -- when payments are received rather than when a PC is shipped. Lenovo's financial reporting is held up as a model in China, where many companies' books are opaque.

And because costs such as warranty payments vary by quarter, it is difficult for Lenovo to precisely gauge the impact of lower warranty liabilities. Johnny Chan, an analyst at J.P. Morgan in Hong Kong, estimates IBM's PC division paid out the equivalent of 7% of revenue for warranties, while Lenovo is paying only 4.5% or so. Based on that estimate and the revenue attributable to the old IBM division in May and June, the savings would have been about $40 million.

Lenovo's other challenges, apart from the difficulties of blending different corporate and national cultures, include overcoming language barriers and gradually substituting IBM-branded products with its lesser-known own name. Job No. 1 is how to bring the IBM operations into the black while maintaining as many of that operation's customers as it can. The former IBM unit's revenue was down 18% in the latest quarter from a year earlier, Mr. Chan estimates.

While Lenovo executives acknowledge some decline, they advise against direct comparisons because of the differences in revenue recognition.

Lenovo hopes to lure more institutional investors and eventually list in the U.S. That might be difficult for the next few quarters, when the company is unable to provide comparable results, Ms. Ma acknowledges. "Shareholders have been asking a lot of questions, but they appreciate the situation," she says. "Well, I would say they understand it." One longtime shareholder is Mark Headley, portfolio manager at Matthews International Capital Management in San Francisco. His company's funds have owned Lenovo shares for more than five years, and Mr. Headley says it acquired more shares when Lenovo's share price tumbled in the weeks after the IBM deal was announced, in December.

Mr. Headley says he realizes "a lot of things are going to be difficult to analyze for a while." He adds, "I think you have to give management at least a year. I'm prepared for a number of bumps along the road for the next two years."