System x Changes Riders – What’s In It For Lenovo And IBM?

Announcement Highlights

• Lenovo to pay IBM $2.3B for its System x business
• 7.5k staff including Adalio Sanchez will join Lenovo
• Lenovo will become IBM’s ‘supplier of x86 server technology’
• Lenovo will resell IBM StorWize storage arrays, GPFS, SmartCloud Entry and some x86 software
• IBM will retain PureApplication and PureData appliances and the Pure brand
• The sale will be completed once regulators have had their say, with ‘business as usual’ until then
• Could make Lenovo the number 4 server player
• Will improve IBM’s profitability

Following the announcement this morning I attended a teleconference with the team driving this deal including Tom Rosamilia (head of STG), Adalio Sanchez (head of System x), Stephen Leonard (head of STG sales) from IBM and Peter Hortensius, head of the Think Business Group, Lenovo. You’ll want to learn more about the consequences.

What’s In The Deal?

The rumours from last year that it would just be the ‘pizza box’ business were significantly understated. It turns out that Lenovo will be taking on all of the System x business including:

• ‘System x, BladeCenter and Flex System blade servers and switches, x86-based Flex integrated systems, NeXtScale and iDataPlex servers and associated software, blade networking and maintenance operations’
• ‘Development, sales and marketing, finance, legal, integrated supply chain, operations, IT and manufacturing’ – in total around 7.5k people including Adalio Sanchez himself and management team

IBM will retain the rest of its System z and Power server and storage businesses of course, as well as the Power-based Flex servers and PureApplication and PureData Appliances. It will also continue to develop software for x86 servers.
The 2 companies plan to enter into a strategic collaboration under which Lenovo will be IBM’s ‘supplier of x86 server technology’ and Lenovo will license, OEM and resell IBM Storwize and tape storage technologies, GPFS, SmartCloud Entry, part of its x86 system software and Platform Computing portfolios. IBM will retain the ‘Pure’ brand, although it looks likely that the PureFlex brand will change when the deal is completed.
The acquisition will cost Lenovo $2.3 Billion – the exact amount of System x hardware revenues in 2014 and, coincidentally the same amount as IBM’s recent investments in new data centres and it’s Watson division. The sale will have to be sanctioned by various regulators, with the 2 companies doing ‘business as usual’ in the meantime.

What Does It Mean For IBM?

On the call the team positioned IBM as a supplier of high-value enterprise offerings and mentioned its recent $1 Billion investment in the Watson Group and $1.2 Billion to boost its SoftLayer acquisition and expand the number of Cloud data centres to 40 in 15 separate countries.
System x is a small proportion of IBM’s $100 Billion overall revenues and yet represents much more to a company with servers in its life-blood. IBM launched its first ‘PC servers’ in 1987 before the Netfinity (1997), X-Architecture (2001), BladeCenter (2002), PureSystems (2012) and NeXtScale (2013). As we saw it launched its X6 machines last week. However HP has always been the x86 leader and – with x86 processors taking a significantly larger share of the whole market in recent years – has pulled clear of IBM in the total server market too.
IBM will need to work much harder on the ‘strategic collaboration’ this time round than it did when it sold Lenovo its PC business in 2005. These servers are fully integrated into its software and services businesses – it has more solution and workload-optimised versions than any other vendor. System x is also part of a complementary server line – IBM has been working hard to break down the silos around its mainframe, Power and 86 lines in recent years.
The figure gives the growth of ‘general business’ and vertical markets taken from IBM’s quarterly financial results, which we believe is the equivalent of SMB v large enterprise and shows a very strong movement towards the former. IBM was keen to counter my suggestion that today’s announcement will push its business the other way, stressing that its SoftLayer business (for instance) gives SMBs bare metal provisioning and IaaS as well as SaaS. From my point of view taking away the most appropriate hardware line is not the best way of going about building its revenues with SMBs.
IBM’s strategy has been to build business in country growth markets over many years. It has had some setbacks with its major markets growing faster and a 22% decline in China – both in the last 2 quarters. As with SMBs System x has been an important driver and it will need a strong partnership with Lenovo to sustain this push into the future.
IBM is very publicly aiming to deliver an EPS of $20 in 2015. Its success can be seen in its strong profitability and high net profits, which stood at 16.5% and $16.5 Billion respectively in 2013. Selling System x shows that it’s prepared to jettison businesses whose low margins could hold up its progress.

What Does It Mean For Lenovo?

The team positioned Lenovo as an expert in scale economies, supply chain optimisation and indirect channels. On our call Peter was keen to point out that the company believes in in-house manufacturing and has an acquisition strategy of taking on the management team of the companies it buys.
IBM definitely helped launch Lenovo as an international PC company in 2005, however it took many years before it rose to take over from HP and Dell as the number 1 supplier – arguably after the brand association with IBM had gone (see figure).
In the year to the end of September Lenovo grew its revenues by 9.8% to $35.8 Billion. Its net profit was $708 Million and profitability just 2.0%. Adding System x will increase its revenues by around 6% and bump up its profits. Our ‘what if’ analysis would make Lenovo the number 4 server vendor based on the last year’s results, however System x sales could decline in the quarters before the deal is confirmed of course.
Can it succeed as a major server vendor? Almost certainly yes, as the addition of the entire System x team should help establish itself quickly and cement the relationship with IBM. But we should remember that there are major differences between PC and server distribution – I believe Acer was unable to bridge the gap a few years ago.

Some Conclusions – It’s Better For Lenovo And System x Than IBM

For us server analysts there have been few more important announcements than this: it’s similar to Oracle buying Sun, HP – Compaq and Compaq – Digital before that. IBM is jettisoning part of its family jewels, getting rid of a low-margin business as it did years ago in PCs, printers and disk drives, which will lessen its visibility in the industry, but help it achieve higher profitability. The acquisition of IBM’s PC business in 2005 formed the foundation for Lenovo’s rise to market leader in 2012 and it is getting another leg-up from IBM to help establish itself in the enterprise market.
Adalio’s reported having positive discussions with a number of major System x customers this morning: nevertheless I think there will certainly be some who are less keen about having Chinese than American servers, but then again there will be many in SMB and growth markets who will welcome them.
Overall I think this is a positive move for System x and Lenovo. I’m currently less convinced for IBM, which will have to work very hard to maintain the high level of integration with its other businesses and overcome the loss of hardware revenues from SMBs and growth markets. Its investments in Watson for cognitive computing and in its Cloud data centres are signs that it plans high-margin business from all from software and services.
Further reading:
What does this mean for other server companies? See our market share ‘what if’
What is Lenovo getting? See our analysis of the new System X6