Case Study on Lenovo and IBM

The Emergence of a Chinese Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division

By John Ackerly & Måns Larsson 1/28

Harvard Business School

The Emergence of a Global PC Giant: Lenovo’s Acquisition of IBM’s PC Division

A Final Paper Submitted to Professor Mihir Desai

By

John Ackerly

Måns Larsson

Cambridge, MA

December 2005



Introduction

On May 1, 2005, the Lenovo Group acquired IBM’s personal computing division (IBM

PC) for $1.25 billion, achieving the goal of its ambitious founder, Liu Chuanzhi, to create a global

PC manufacturing powerhouse. By transforming itself from an upstart company focused on its

domestic market, Lenovo joined an exclusive club of Chinese companies, such as Huawei and

TCL, which compete head-to-head with leading multinational corporations.

Without the involvement of western private equity firms – Texas Pacific Group (TPG),

Newbridge Capital,1 and General Atlantic Partners (GA) – this transaction may never have been

consummated. Each firm brought crucial expertise and credibility that helped mitigate the

significant financial, operational and cultural risks inherent in a large scale, cross-border

transaction. Many believe that these efforts opened a new chapter in the growth of China’s

economy and its integration with the West. As Bill Grabe, GA’s representative on Lenovo’s board,

stated: “Lenovo’s acquisition of IBM mark the start of something bigger. In the future, we will see

more Chinese global giants emerging through cross-border M&A.”2

This paper examines the underlying motivations and assumptions of each party in the

transaction. While this transaction had many risks, we conclude that the strategic rationale was

sound, the ultimate valuation was fair, and that all players are positioned to benefit: IBM shed a

resource consuming, non-core asset; Lenovo leapfrogged to global leadership; and, the private

equity players negotiated and structured a deal with significant upside potential with limited

downside.

The paper reaches these conclusions by answering four key questions:

• What was the strategic rationale for and key risks of the acquisition?

• Why did the private equity buyers get involved in the transaction? What were the

underlying motivations of the interested parties?

• How was the deal structured to address the assumed risks?

• How did Lenovo think about the valuation of IBM PC? What was the “fair” value of IBM

PC at the time of the transaction?

1 Newbridge Capital is an affiliate of TPG. Hereafter, “TPG” will refer to Newbridge as well as the Texas Pacific Group. 2 William Grabe, interview by authors, December 6, 2005.



SECTION 1: What was the strategic rationale for the acquisition and what

were the key risks?

Strategic rationale

The Lenovo-IBM PC transaction was underpinned by sound industrial logic. The

complementary nature of their businesses across geographies, products and areas of functional

strength opened a number of win-win opportunities for buyer and seller. As outlined below,

though the deal offered significant opportunity for revenue synergies, the cross-border

combination ultimately was viewed as “cost play” by the parties involved.

When IBM decided to spin out its PC division in April 2004, its motivations were clear: the

division recorded a net loss of $258 million in 2003 and $171 million in 2002 and had required a

total parent company equity infusion totaling $987 million as of June 2004.3 In addition, the

division was an “orphan” within the organization, as it did not fit within IBM’s broader strategy to

focus on higher margin enterprise and services businesses.

The initial interest in IBM PC came from financial buyers such as TPG who were attracted

to the carve-out of IBM PC as a stand alone entity.4 These players sought to realize gains through

leverage and achieve significant cost savings, particularly through aggressive procurement

rationalization and jettisoning IBM’s expensive back-office support such as call centers and human

resource functions. 5 According to Morgan Stanley, IBM PC’s SG&A expense ratio of 10% is

significantly higher than the industry average of 6.8%.6 While TPG did not rely on potential

revenue growth to justify the attractiveness of the carve-out opportunity, they did acknowledge the

potential upside of bringing focus to IBM PC’s consumer business in emerging markets.7

The strategic rationale for the stand-alone carve-out opportunity holds for the Lenovo-IBM

PC business combination and is further enhanced by the fit of the Lenovo and IBM PC businesses.

Prior to the transaction, Lenovo was the undisputed leader in the China PC market with 27%

market share, a low cost position that resulted in gross margins of 13.3% (versus 10% for IBM PC), 3 Lenovo, December 31, 2004, Circular; Very Substantial Acquisition Relating to the Personal Computer Business of International Business Machines Corporation, Hong Kong Stock Exchange, p. 149, p. 226. 4 William Grabe, interview by authors, December 6, 2005. 5 Winston Wu, interview by authors, December 6, 2005. 6 Victor Ma, Big is Beautiful, Morgan Stanley Equity Research, April 19, 2005, p. 1. 7 Winston Wu, interview by authors, December 6, 2005.



and enjoyed particular strength in the desktop and fast growing consumer market. For example, its

handset sales grew 100% in 2004.8 However, it lacked global reach and scale. IBM PC, on the

other hand, operated in 160 countries across the globe, was a leading innovator, owned a strong

brand – particularly “ThinkPad” in the laptop market – and boasted best-in-class service

capabilities. However, the division had virtually abandoned the consumer business, had a weak

desktop business and limited reach into China. The business combination would create the 3rd

largest competitor in the PC market with 8% market share across the desktop, laptop and consumer

segments supported by unparalleled global sales, marketing, distribution and customer support

infrastructure.9 Sales of the combined group outside China were expected to be 72% of total sales,

versus 2% for Lenovo on a stand-alone basis.

The combined entity’s global infrastructure would help drive cost savings by marrying an

efficient supply chain with a low cost manufacturing base. The parties estimated that Lenovo-

IBM’s scale would create cost synergies of $150-200 million a year on procurement savings alone,

as Lenovo could get better pricing on such components as Intel chips by purchasing in bulk.10

Analysts have estimated that these procurement savings account for 60-70% of total savings.11

These benefits would be further enhanced by sharing of best practices, consolidation of vendor

lists, and increasing the use of standardized parts by consolidating product lines. In addition,

analysts estimate that Lenovo and IBM would be able consolidate 16 functional areas achieving

savings of $10-30 million.12

As mentioned above, Lenovo, IBM and the private equity players also recognized the

potential for revenue synergies. Particularly attractive to Lenovo and the private equity investors

was the opportunity to sell Lenovo’s low cost consumer products in emerging markets through

IBMs extensive distribution network.13 In addition, TPG was optimistic that Lenovo would be

able to take market share from Dell and HP in the U.S. consumer market.14 Finally, IBM PC

traditionally sold its PCs to its IBM parent at cost. Under the terms of the deal, Lenovo would be

able to achieve attractive margins on computers sold to IBM.

8 William Grabe, interview by authors, December 6, 2005. 9 Lenovo, December 31, 2004, Circular; Very Substantial Acquisition Relating to the Personal Computer Business of International Business Machines Corporation, Hong Kong Stock Exchange, p. 149, p. 48. 10 The figure assumes that Lenovo-IBM could get similar terms to Dell and H-P. 11 Max Chen , interview by authors, December 1, 2005. 12 Max Chen , interview by authors, December 1, 2005. 13 William Grabe, interview by authors, December 6, 2005. 14 Winston Wu, interview by authors, Cambridge, MA, December 7, 2005.



Deal risks

This section highlights the key risks facing each party. While the industrial logic of the

Lenovo-IBM PC was clear, the transaction was fraught with risk. Due to the complex, cross-

continental nature of the deal and the predictable political angst spurred by the announcement, the

transaction left the involved parties exposed to significant financial, operational and reputation risk.

Cave-out risks

Even on a stand-alone basis, the carve-out of IBM PC from IBM’s operations would pose

significant challenges. According to Winston Wu, a member of the TPG deal team, “The carve-

out of IBM PC is the most complex carve out ever attempted by a private equity firm”15 IBM PC

was not organized as a separate stand-alone unit with its own functions within IBM. Rather, IBM

PC benefited from centralized functions run by its parent, such as global procurement, sales and

distribution as well as back-office support such as accounting, finance and human resources.

These intricate links with the parent company added to the difficulty of structuring a share

purchase agreement. In order to solve the issue of the IBM PC’s deep dependence on IBM, the

transitional services agreements became important components of the negotiations and the

transaction. This paper looks at these agreements in some detail in Section 3 below.

Lack of financial transparency

The dependence of IBM PC on its parent also made it difficult to fully understand its “true”

underlying financial performance. According to PriceWaterhouseCoopers: “The historical

financial statements may…not reflect the results of operations, financial position or cash flows that

would have resulted had the [Company] been operated as a separate entity.”16 For example, as

discussed above, IBM PC is using its parent’s sales force and distribution channels and relies on its

corporate functions. While IBM PC had historically paid its parent for many of these services, it is

unclear if the prices paid represented “fair market” prices.

Financial dependence of IBM PC on its parent 15Winston Wu, interview by authors, Cambridge, MA, December 7, 2005. 16 PriceWaterhouseCoopers, “Report of Independent Registered Public Accounting Firm To the Stockholders and Board of Directors of International Business Machines Corporation,” as reprinted in Circular, p. 115.



IBM PC relied on its parent for customer financing. IGF, IBM’s financing arm, originated

commercial loans to finance dealer and remarketer purchases of the Company’s products to the

tune of US$6.7 billion and US$6.0 billion in 2003 and 2002, respectively. These loans represent

over 60% of the Company’s sales. Again, ensuring that IBM PC continued to receive these

financial services became a significant issue in the negotiations. Similarly, as a part of the IBM

group, IBM PC had access to its parent company’s war chest, which was an essential tool in

managing the cyclicality of the business. IBM PC had tremendous intra-quarter working capital

swings which approached 10% of annual sales. According to TPB, “[IBM PC’s] intra-quarter

working capital swings could be as large as US$1 billion.”17 A big worry for the parties involved

in the transaction was to what extent the Company would have sufficient cash and/or credit lines to

manage these working capital movements.

Integration risks: cultural and operational

In addition to the issues specific to a carve-out from IBM, the combination of a Chinese

and U.S. firm posed a host of additional risks. For example, the cultural and operational

integration challenge was significant and could have potentially derailed the deal. The two

companies had distinct cultures: IBM PC was an established global business with a Western

management mindset, whereas Lenovo was a purely China-focused company run by local Chinese

entrepreneurs. Further, according to IBM accounting, its PC division had been operating at a loss

for years. Lenovo’s management had very limited experience operating outside China, and there

was a risk that the key US management needed to run the international portion of the combined

business might leave because of potential cultural clashes. As the Economist noted, “Lenovo might

make things worse, given cultural differences between Americans and Chinese, big differences in

pay and the need for interpreters at every meeting.”18 Indeed, cultural differences have plagued

Chinese-Western mergers in the past. Vincent Yan, finance director of TCL, which merged with

the French television manufacturer Thomson, has admitted that “the cultural gap proved wider

than expected.”19

The integration also presented several operational risks. It would not be an easy task to

subsume a global icon operating in 160 countries within a company one third its size that operates 17 Ibid. 18 “Champ or chump?,” The Economist, December 9, 2004, 19 Ibid.



in only one country. Not only would the challenge of combining the two businesses in their

current format prove difficult, but also the planned restructuring of the supply chain and

manufacturing added significantly to that risk. In particular, successfully executing two major cost

initiatives fundamental to the industrial logic of the acquisition was far from assured. Achieving

preferential terms from suppliers and fully leverage Lenovo’s low cost infrastructure to reduce the

global operating costs very ambitious goals that had never before been attempted by a Chinese

company.20 According to Jeannie Chung at CSFB, “so far, no Chinese company has successfully

turned loss-making overseas assets into a profitable business. Lenovo could hardly be an

exception.”21

An additional question was what would happen to Lenovo after the negotiated services

agreements with IBM had disappeared. As this paper discusses in Section 3, the interim services

agreements gave Lenovo-IBM PC access to IBM sales network, business partners and distributors

as well as its financing arm and its warranty services.

Political risk

When the deal was announced there was a loud cry by politicians in the United States. At

the outset, there seemed to be a risk that the deal would not get approval. Several senior

Congressmen lobbied against the deal, claiming that it would “allow the Chinese government to

acquire sensitive American technology, and potentially, use IBM’s facilities to spy for the Chinese

armed forces.” 22 They cited the fact that the Chinese Academy of Sciences was a major

shareholder of the firm. These very same Congressmen wrote to the Treasury Secretary, John

Snow, to argue that “the deal may transfer advanced US technology and corporate assets to the

Chinese government.”23 While many viewed these activities as shrill political posturing, the

Committee on Foreign Investment in the United States extended its routine 30-day investigation by

45 days to perform a more thorough investigation. In addition to approval risk, the key players

were concerned that Lenovo-IBM PC would lose IBM PC’s U.S. government contract, which

represented approximately 7% of total IBM PC sales.

20 Ibid. 21 Jeannie Cheung, et al., Lenovo Group: Powering Up, April 12, 2005. 22 “I spy spies,” The Economist, ´February 3, 2005. 23 Ibid.



Competitive response risk

At the time of the deal, the potential negative impact of these uncertainties were

compounded by the likely opportunistic response by Dell and Hewlett-Packard, who likely would

endevour to target IBM PC customers between the announcement the transaction and a successful

close and subsequent integration. A.M. Sacconaghi at Sanford Bernstein Research argued that

“the main issue in relation to the sale is the ability of [IBM PC] to retain PC customers, especially

over the next six months, before the deal closes, as Dell and Hewlett-Packard will probably aim to

capitalize on the uncertainty among IBM customers by aggressively seeking them out.”24 There

was a significant risk that the IBM PC brand would be tarnished by the competition as they would

try to “steal” the Company’s customers. In addition, by competing head to head with Dell and H-P,

IBM PC might have to match aggressive pricing, thereby cutting into the firms profitability.

Brand risk

Just like there was a worry that a potential political backlash in the US and an attack by

IBM PC’s competition could negatively affect sales, there was a concern that the transaction would

result in a degradation of the “ThinkPad” brand around the world. Indeed, there was a risk in

combining the “high-end” IBM brand with the “lower end” Lenovo brand. How would consumers

react to the change of control? IBM Thinkpad stood for quality and “made in America” (even

though most production took place offshore even under IBM’s ownership). Furthermore, there

was a second degree of brand risk, five years after the transaction when Lenovo would lose the

right to use the “IBM” brand. Lenovo’s lack of brand recognition outside of China could require

that it spend more than expected on marketing promote its brand in anticipation of the expiration

of the five-year term.

24 A.M. Sacconaghi, et al., “IBM: PC Business Sale Immaterial But Risks ‘Growth Gift’ to Rivals,” Bernstein Research, December 17, 2004, p. 1.



SECTION 2: How and why did the private equity buyers get involved in the

transaction? What were the underlying motivations of the interested parties?

Ironically, it was this set of complex risks that opened the door to private equity

participation. GA and TPG were able to demonstrate to Lenovo and the Chinese government that

they could provide crucial assistance in navigate the financial, operational and cultural hazards of

the transaction.

The deal was the first of its kind. Prior to the Lenovo-IBM transaction, virtually all private

equity investment in China was growth capital transactions with an average deal size of $22

million.25 Successful deals tended to be focused on exporting successful U.S. business models to

China in order to access the domestic Chinese market. In contrast, this deal was driven by

Lenovo’s interest in finding private equity partners who could “…offer expertise and experience

that are expected to be valuable to the Company” in its global expansion.26 In addition, Lenovo

believed that the involvement of the three private equity firms would validate their investment

thesis and enhance its credibility in the global capital markets, increasing the likelihood of a

successful listing on US stock exchange in the future.

GA provided due diligence assistance to help Lenovo assess the IBM PC opportunity

during the auction process in order to win the option of participating in a potential deal as a

minority investor.27 GA had been operating in China for five years through their investment in e-

commerce software and services company, Digital China, a subsidiary of Lenovo’s parent

company, Legend holdings. GA helped Legend spin out Digital China helped and take it public on

the Hong Kong stock exchange. Through this investment, GA formed a close relationship with Liu

Chuanzhi, the Chairman and Founder of Legend. Liu reached out to William Grabe, a former

long-time IBM executive and partner at General Atlantic to ask GA to help evaluate the IBM PC

business.

TPG partnered with Lenovo later, after having lost the auction for the IBM PC division to

Lenovo in December 2004. TPG offered operational knowledge, global private equity transaction

experience and carve-out expertise in return for opportunity to become a significant minority

25 Guide to Venture Capital in Asia (2004). 26 Lenovo, December 31, 2004, Circular; Very Substantial Acquisition Relating to the Personal Computer Business of International Business Machines Corporation, Hong Kong Stock Exchange, p. 149, p. 2. 27 William Grabe, interview by authors, December 6, 2005.



shareholder.28 In addition, TPG gained a deep understanding of the IBM PC business through six

months of due diligence during the auction process. When it lost the auction, TPG approached

Lenovo about joining forces through a minority investment. TPG was one of many players who

asked to participate, but Lenovo readily agreed to TPG’s involvement because of TPG’s strong

reputation as an operationally focused partner and its grasp of the IBM PC business. In fact, upon

completion of the transaction, TPG inserted one of their supply chain experts into Lenovo with a

direct report to their CEO to drive operational efficiency initiatives.

GA and TPG believed that this transaction could ultimately return as much as seven times

their money. Taking into account synergies, TPG estimates that it invested at a single digit

EBITDA pro forma multiple.29 Importantly, GA and TPG/Newbridge were in agreement on the

key governance issues and direction in which the firm needed to be taken. In particular, they

presented a united front with Lenovo in sometimes heated deal structure negotiations around such

issues as minority voting rights and board representation.

28 Winston Wu, interview by authors, December 6 2005. 29 Winston Wu, interview by authors, December 6 2005.



SECTION 3: How was the deal structured to address the assumed risks?

Satisfying all parties proved difficult and demanded a complex deal structure. According

to Andrew Right, a member of the Goldman Sachs team that advised Lenovo in the transaction:

“This transaction stretched the negotiators on both sides of the table to the limit…the complexity

of the deal forced us to be extremely innovative in the structuring of the transaction.”30 Also,

given the sensitivity of the discussion some of IBM PC’s key managers were kept out of the

negotiations in order for them to preserve a good relationship with their new colleagues at Lenovo

following the transaction. The proposed new CEO of Lenovo-IBM PC, Steve Ward, “was kept out

of the acrimonious negotiations in order to facilitate the post-merger cultural integration.”31

Original deal: pre-private equity involvement

The private equity firms were not involved in the original deal agreed in December 2004.

According to the original agreement, Lenovo would acquire the IBM PC business, including the

desktop and notebook product lines, corresponding R&D and manufacturing facilities. The total

consideration of the transaction was US$1.25 billion plus the assumption by Lenovo of

approximately US$500 million of working capital related liabilities (not considered part of the

enterprise value since the Company has negative net working capital). Lenovo would pay the

consideration in US$600 million of equity and US$650 million in cash, resulting in an 18.9%

ownership in the new entity for IBM. The cash consideration would be paid with US$150 million

from internal sources and US$500 million from a bridge loan provided by Goldman Sachs.

Final deal: private equity firms get involved

The original deal was changed quite dramatically when the private equity firms became

involved in the spring of 2005. TPG and GA paid US$350 million in a convertible preferred

equity instrument that upon conversion equaled 10.24% of Lenovo-IBM PC’s share capital. In

addition, the private equity firms received warrants that if exercised amounted to an additional

2.63% of the firm’s fully diluted share capital.

30 Andrew Right, Q&A discussion after Lenovo-IBM presentation at HBS, November 21, 2005. 31 Andrew Right, Lenovo-IBM presentation at HBS, November 21, 2005.



As a result of the involvement of the private equity firms, IBM would get a larger portion

of the consideration in cash and its resulting equity stake in the Company would be decreased from

18.9% to 8.8%. IBM got approximately US$800 in cash and Lenovo-IBM PC common shares

representing a value of US$450 million, instead of US$600 million (based on the HK$2.675, the

closing price of Lenovo’s shares on the last day of trading prior to the December 2004

announcement). Table A provides a summary of the pre- and post transaction ownership structure.

Table A: Pre- and post-transaction ownership structure

Source: Lenovo32

32 Lenovo, Proposed Issue of Unlisted Convertible Preferred Shares and Unlisted Warrants, March 30, 2005, p. 13.



Economic terms and rationale of strategic investment by private equity firms

The private equity firms structured their investment as a PIPE (private investment in a

public entity) and got convertible preferred shares. The key terms of their investment were as

follows:33

• Consideration: US$350 million

• Preferred shares: 2.73 million unlisted preferred shares equaling 10.24% of the Company

on an as-if-converted basis

• Key terms of the preferred shares:

o 4.5% annual preferential cash dividend, payable quarterly

o Convertible into 1,001.8 million common shares, at any time, at a conversion price

of HK$2.725

o Redeemable after 7 years at a price equal to the stated value plus accrued interest

o 12 months lock-up period

• Warrants: in addition, the private equity firms got unlisted warrants giving them the right to

subscribe to 237.4 million common shares

By investing in preferred shares, the private equity players gave themselves significant

downside protection. In the case of a bankruptcy or liquidation, their stake (unless converted)

would give them rights to any proceeds before the holders of common equity. Similarly, the

warrants gave them a “booster” if Lenovo performed well. If they exercised the warrants, they

would receive an additional ownership stake of approximately 2.63%. Of course, TPG and GA

would only exercise the warrants if the share price exceeds the original share price since the strike

price of the warrants is equal to share price at which they bought their equity stake.

Corporate governance

The private equity firms, who typically only invest when can enjoy a control position,

structured the deal to ensure they had a strong voice in any key decision made by Lenovo

management. For example, while PE firms hold just over 10% of the economic ownership in the

Company, they have the right to appoint more than 33% of the board (2 directors for TPG, 1 for

GA and 1 independent director). 33 Ibid. and CSFB Research.



Table B: Board Structure

Lenovo-IBM PC's Board Composition and Representation

Board Memebrs No. of Seats % of Representation

Lenovo Chairman (Yang Yuanquing) 1 8.3%Lenovo (Steve Ward) 1 8.3%Lenovo CFO (Mary Ma) 1 8.3%Legend Holdings (Liu Chuanzhi) 1 8.3%Legend Holdings (Zeng Maochao) 1 8.3%TPG 2 16.6%GA 1 8.3%Independent Non-Executive Directors 4 33.2%Total 12 100.0%

Source: Circular, CSFB Research

In addition, the private equity firms gained significant minority rights. The private equity

firms were particularly concerned about having control over key management changes and

acquisitions and disposals.34 According TPG, “having blocking rights for key decisions that could

potentially change the future of the Company was essential for us, even though we did not have a

majority equity stake in the business.”35 While not providing outright control, these key minority

rights would allow the private equity firms to block any major decision that they viewed to be

contrary to their interests.

Key issues in the share purchase agreement

Given the intricate relationship between IBM PC and its parent, the share purchase

agreement was carefully structured to handle the transition issues which we outlined in the “Deal

Risks” section above.

To handle the risks associated with legacy issues, IBM was responsible for warranty

liabilities stemming from any computer sold before the transaction closing date. According to the

publicly available summary of the share purchase agreement, “all warranty, enhanced warranty

and maintenance obligations relating to or arising from the products sold or shipped by the

business prior to the initial closing” will be excluded from the transaction.36 Similarly, “all

liabilities to the extent relating to or arising from any defect in the design, manufacture, quality, 34 Winston Wu, interview by authors, December 6, 2005. 35 Winston Wu, interview by authors, December 6, 2005. 36 Letter from the Lenovo Board to the Shareholders, December 31, 2004, as reprinted in Circular, p. 13.



conformity to specification or fitness for purpose of any product sold and shipped by the business

prior to the initial closing” would be paid by IBM37 In 2003, warranty claims cost IBM PC $200

million and they are expected to total US$250-400 million in both 2005 and 2006.38

The Transitional Services Agreement handled the issues related to the complexity of the

carve-out. Since IBM PC was fully integrated with IBM’s other businesses it was not feasible for

Lenovo to acquire all the assets from IBM. The Transitional Service Agreement ensured that IBM

would provision services to allow for a smooth ownership transition.

The Strategic Financing and Asset Disposition Services Agreement was structured to

handle the financial dependence of IBM PC on its former parent. This agreement effectively

allowed Lenovo’s customers to lease products through IBM’s financing arm. In other words, IBM

will finance Lenovo’s customers’ purchases of its computers. This was extremely important for

the deal, since, as we pointed out above, some 60% of all historical purchases were financed by

IBM.

To address the operational integration risks, the parties entered into the IGS Services

Agreement39 and the Marketing Support Agreement. The GS Services Agreement ensured that

IBM’s services arm provided after-sales service with global coverage for Lenovo-IBM PC’s

customers. This was important and ensured that Lenovo-IBM PC maintained the “industry best

award-winning warranty service to which IBM’s customers are accustomed” 40 “Under the

Marketing Support Agreement, IBM PC will be able leverage IBM’s well established enterprise

sales force and established global sales infrastructure, i.e. client representative teams, for a period

of five years.”41 Again, these agreements were designed to allow for a smooth transition to the

new owners, protected the business’s momentum, provided for a gradual and problem-free transfer

of the customer relationships to Lenovo’s team.

To avoid losing its key customer, IBM, to the competition, the Internal Use Purchase

Agreement stated that Lenovo will the “preferred and nearly exclusive (95%) supplier for all

personal computers purchased by IBM for its internal use or strategic outsourcing deals for a

period of five years.”42 Finally, as highlighted above, to mitigate the significant brand risk IBM

37 Ibid. 38 Winston Wu, interview by authors, December 6, 2005. 39 IGS is IBM’s global services business. 40 Circular., p. 50. 41 Ibid., p. 51. 42 Ibid., p. 51.



allowed Lenovo to use the “IBM” brand for a five year transition period and Lenovo would be

allowed to keep the “Think” brand forever.

SECTION 4: How did Lenovo think about the valuation of IBM PC? What was

the “fair” value of IBM PC at the time of the transaction?

In this section, we value IBM-PC at the time of the original transaction based on

assumptions we developed through studying public documents and though our discussions with

individuals intimately involved in the transaction. While not willing to share their actual valuation

models with us due to confidentiality issues, the key players in the transaction – including Bill

Grabe, a Lenovo Board member, the Goldman Sachs deal team, and principals at both TPG and

GA – shared their views on the company, its future prospects, and the key drivers of their

valuations.

All parties felt that the $1.25 billion valuation of IBM PC was a “good deal”. According to

TPG: “While on the surface the valuation may seem rich given IBM PC’s negative net income, we

felt we were investing at a very attractive valuation multiple on a pro forma basis.” On the base

case analysis, all players came out at a similar place. Ultimately, the parties believe that success

or failure of this transaction would be determined by whether or not the combined entity would be

able to deliver on the cost savings potential.

The model presented below confirms that the assessment whether $1.25 billion

consideration was a “fair price” is fundamentally shaped by one’s assumptions around achieving

cost synergies. The base case assumptions were informed by third party research and the

interviews outlined above. In addition, we conduct a sensitivity analysis that seeks to captures the

impact of different assumptions around cost and revenue synergies as well as cost of capital.

Key Base Case Operating Assumptions

The discussion below highlights the key drivers of our base case valuation analysis:



Revenue Growth: We believe that IBM PC would lose market share as competitors capitalize on

the inevitable uncertainty created by transaction to steal customers. In addition, we believe that it

IBM PC may lose a portion of their U.S. government agency business, which represents an

estimated 6-7% of total sales. We assume a five percent volume drop for non-IBM sales in 2005

and volume growth of four percent stemming mainly from the company’s ability to more deeply

penetrate emerging markets and grow the consumer market in the U.S. On the pricing side, we

assume the historical trend of pricing pressure will continue and therefore project an annual 2.5%

price decline in line with current trends. The net result is marginal revenue growth of 1.4%.

Table C: Revenue growth drivers Actual2004 2005 2006 2007 2008 2009 DRIVER

NET REVENUEExternal SalesVolume 100.0% 95.0% 98.8% 102.8% 106.9% 111.1% 4.0%Price 100.0% 97.5% 95.1% 92.7% 90.4% 88.1% -2.5%Net Volume-Price Effect 100.0% 92.6% 93.9% 95.2% 96.6% 97.9%Net Revenue Growth -7.4% 1.4% 1.4% 1.4% 1.4%

Sales to IBMVolume 100.0% 100.0% 104.0% 108.2% 112.5% 117.0% 2.0%Price 100.0% 97.5% 105.6% 103.0% 100.4% 97.9% -2.5%Net Volume-Price Effect 100.0% 97.5% 109.9% 111.4% 112.9% 114.5%Net Revenue Growth -2.5% 12.7% 1.4% 1.4% 1.4%

Projected

Gross Profit Margins: We assume margin improvement over five years for IBM PC, ultimating

reaching Lenovo’s 13% margin in 2009. Approximately half of the margin improvement is a

result of the $150-200 million procurement savings per year. The remainder stems from the

operational rationalization of the business, including moving manufacturing to China.

Table D: COGS drivers

Actual2004 2005 2006 2007 2008 2009

COGSAs % Net Revenue EXTERNAL Sales 89.7% 89.5% 89.0% 88.0% 87.5% 87.0% Sales to IBM 100.0% 95.0% 90.0% 88.0% 87.5% 87.0%

Projected

Operating Expenses: As noted in the “Strategic Rationale” section of the paper, the industry

SG&A expense ratio average is 6.8% and Lenovo’s current expense ratio is 4%. We assume that



the IBM PC portion of the business reach the industry average by 2009. We assume no increase or

decrease in R&D expenses as a percentage of revenue.

Table E: Opex drivers

Actual2004 2005 2006 2007 2008 2009

EXPENSESSG&A as % of Net Revenue 10.3% 10.3% 9.0% 8.0% 7.0% 6.8%R&D as % of Net Revenue 1.3% 1.3% 1.3% 1.3% 1.3% 1.3%

Projected

Warranty Savings: We assume a warranty savings in 2005 of $324 million and $235 million in

2006, in line with Goldman Sachs and TPG estimates of between in $250-400 million per year.

We would expect there to be additional warranty savings past 2006. However, since most

warranty contracts are for three years or less and IBM only covers warrant contracts entered into

prior to the acquisition, we expect these savings to be negligible.

Table F: Warranty savings

Actual2004 2005 2006 2007 2008 2009

WARRANTY SAVINGSAs % External Net Revenue N.A. 3.5% 2.5% 0.0% 0.0% 0.0%

Projected

Effective tax rate: Tax expense charged to Lenovo-IBM PC during the first quarter of 2005 was

equivalent to a 29.5% effective tax rate, significantly higher than the 2% that Lenovo has been

historically charged in China, where it has received preferential tax treatment. The steep increase

in the effective tax rate results from the Company’s operations in higher-tax regimes such as the

United States and Japan. According to Viktor Ma at Morgan Stanley, the company expects the tax

rate to stay around the 29-30% level for the next year but will look for tax arrangement

opportunities to lower the effective rate in the future.43 For the purposes of our analysis, we

assume that IBM PC has a tax rate that is equivalent to the combined business. We believe that the

tax rate will decrease, due to the combination of expansion into lower-rate tax regimes and more

effective tax planning, and stabilize at a level of around 25%. 43 Viktor Ma, “Great Start,” Morgan Stanley Research, August 12, 2005, p. 5.



Working Capital and Capital Expenditures: We assume that working stays a constant -6.6% of

sales and that capital expenditures increases from the current 1% of net revenues to 1.5% of net

revenues to account for potential capital outlays in addition to maintenance capital expenditures.

Cost of Capital

We assume a 15.9% cost of capital. We used the WACC methodology to calculate the cost

of capital, since we believe that it is a reasonable assumption to assume a steady debt-to-equity

ratio for this business on an ongoing basis. We arrive at the cost of capital by looking at the betas

of three comparable companies in the global PC business – Apple Computer, Dell and Hewlett

Packard. We then unlevered the equity betas. Since the three comparable companies all have

significant cash positions, we examined their historical financials and noted that have had

significant cash balances over the past five years. We took the average cash balance and treated it

as operational cash and the remainder as excess cash, used to calculate the “real” level of negative

net debt (cash) that should be used to unlever the betas. For the details of the calculations, please

see Table G below.

Table G: Asset beta calculation based on comparable companies Equity Market Net debt/ Operating Excess Asset

Comps Beta Cap TEV (Cash) Cash Cash D (cash)/V Adj. E/V Beta

Apple Computer 1.50 62,644 54,383 (8,261) (2,500) (5,761) (0.11) 1.11 1.66 Dell 1.22 75,713 67,082 (8,631) (5,000) (3,631) (0.05) 1.05 1.29 Hewlett-Packard 1.77 85,721 77,015 (8,706) (6,500) (2,206) (0.03) 1.03 1.82 Average 1.50 1.59

We then used the average asset beta of the comparable companies to calculate the cost of

capital for IBM PC. We assumed a risk-free rate of 4.5%, based on the U.S. 10-year treasury.44

Though we believe that it is not fully representative of future expected equity market risk premium,

we used the best available historical estimate, namely 7.2%. We then used the CAPM to calculate

the weighted average cost of capital, assuming an ongoing sustainable debt level of zero.

44 Financial Times



Table H: Cost of capital assumptions

COST OF CAPITAL ASSUMPTIONS

Risk free rate 4.5%Market risk premium 7.2%Comps asset beta 1.59 IBM PC D/E 0.0%IBM PC D/V 0.0%IBM PC E/V 100.0%IBM PC equity beta 1.59

WACC 15.9%

It is worth noting that Even Goldman Sachs admitted that finding the right cost of capital

for this complex multi-national, multi-currency transactions was “a big challenge.”45 During our

conversations, they mentioned that they thought that “13% was a reasonable number to use for

WACC,” without giving any real justification for the figure.46 They did mention, however, that

they believed that using a market-risk premium of 5.0% instead of 7.2% was reasonable.47 So,

applying the Goldman Sachs best-estimate of the market-risk premium yields a WACC of 12.7%,

which is very close to the quoted 13%.

Moreover, instead of trying to incorporate the “risks” of the transaction in the WACC, we

believe that the best approach is to assess these risks through a sensitivity analysis rather than

“baking” these risks into a single cost of capital figure. Our sensitivity analysis helps us

understand the risks much better than would a more “sophisticated” – and, frankly, in our opinion,

convoluted – calculation of WACC using country specific risk premiums and any idiosyncratic

risks associated with the deal.

Discounted Cash Flow Valuation

Based on the above assumptions, we calculated the enterprise value of IBM PC using a

discounted cash flow model. To calculate the terminal value, we have assumed a terminal growth

rate of 1.5%, in line with the net revenue growth of 1.4%. Please see Table I below for a summary

of the DCF.

45 Max Chen, interview by authors, December 1, 2005. 46 Max Chen, interview by authors, December 1, 2005. 47 Max Chen, interview by authors, December 1, 2005.



Table I: Discounted cash flow analysis

Actual2004 2005 2006 2007 2008 2009

EBIAT CALCULATIONEBIT (91) 266 362 329 483 560 less Taxes (167) (78) (98) (85) (121) (140) EBIAT (258) 187 264 243 362 420

CASH FLOW CALCULATIONEBIAT (258) 187 264 243 362 420 plus Depreciation/Amortization 100 100 120 130 135 145 less change in NWC - 49 (11) (9) (9) (9) less Capex (103) (95) (145) (147) (150) (152) plus other non-cash items - - - - - - FREE CASH FLOW (261) 241 228 217 338 404

Discount factor 0.86 0.74 0.64 0.55 0.48 PV of Free Cash Flows 207.7 169.6 139.1 187.3 193.1 Terminal value 1,357.3

Sum of PV of Free Cash Flow 896.8 PV of Terminal Value 648.0 Total Enterprise Value 1,544.8

Projected

Valuation Discussion

Our base case assumptions yield a value for IBM PC of US$1.54 billion, 23% higher than

the price actually at the time of the transaction. However, we recognize that the valuation is very

sensitive to certain key assumptions. We have analyzed the valuation sensitivity to the cost of

capital assumptions, the terminal growth rate, the COGS and the SG&A as a percentage of net

revenues. Please see the Table J below for the results of the sensitivity analysis. It is worth

noting that the analysis confirms the view that the Lenovo-IBM PC transaction is a “cost play.”

For example, the enterprise value would increase by only $111 million dollars with an increase in

the terminal growth rate by 2% (an increase from 1% to 3% at a 15.9% cost of capital), whereas

the enterprise value is increased by almost five times that much with either a 2% improvement in

COGS or SG&A (again, at 15.9% cost of capital).



Finally, we believe that next logical step in this analysis would be to perform the same

analysis for the combined Lenovo-IBM PC business to fully understand the value proposition to

the private equity sponsors, given that ultimately they made investments in the combined business.

Table J: Sensitivity analysis

Enterprise Value - Terminal Growth Rate & Cost of Capital

1,544.80 0.00% 0.50% 1.00% 1.50% 2.00% 2.50% 3.00%11.0% 2,318 2,387 2,462 2,545 2,638 2,741 2,857 12.0% 2,081 2,134 2,191 2,254 2,324 2,401 2,486 13.0% 1,885 1,927 1,972 2,020 2,074 2,132 2,196

Cost of 14.0% 1,723 1,756 1,791 1,829 1,871 1,916 1,965 Capital 15.0% 1,585 1,612 1,640 1,670 1,703 1,739 1,777

15.9% 1,475 1,497 1,520 1,545 1,571 1,600 1,631 17.0% 1,368 1,385 1,404 1,424 1,445 1,468 1,492 18.0% 1,280 1,295 1,310 1,326 1,344 1,362 1,382 19.0% 1,204 1,216 1,229 1,242 1,256 1,271 1,287 20.0% 1,137 1,147 1,157 1,169 1,180 1,193 1,206

Terminal Growth Rate

Enterprise Value - COGS 2006-onward & Cost of Capital

1,120.62 91.0% 90.0% 89.0% 88.0% 87.0% 86.0% 85.0%11.0% 781 1,269 1,757 2,246 2,734 3,223 3,711 12.0% 707 1,140 1,573 2,006 2,439 2,872 3,305 13.0% 648 1,036 1,425 1,813 2,201 2,590 2,978

Cost of 14.0% 599 951 1,303 1,654 2,006 2,358 2,709 Capital 15.0% 559 880 1,201 1,522 1,843 2,164 2,486

15.9% 527 824 1,121 1,417 1,714 2,011 2,308 17.0% 496 769 1,043 1,316 1,589 1,863 2,136 18.0% 471 725 980 1,234 1,488 1,743 1,997 19.0% 449 687 925 1,163 1,401 1,639 1,877 20.0% 430 654 877 1,100 1,324 1,547 1,771

COGS 2006-onward



Enterprise Value - SG&A 2006-onward & Cost of Capital

1,068.38 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0%11.0% 686 1,176 1,667 2,157 2,647 3,137 3,628 12.0% 624 1,059 1,494 1,928 2,363 2,798 3,233 13.0% 574 964 1,354 1,744 2,134 2,524 2,914

Cost of 14.0% 533 886 1,240 1,593 1,946 2,300 2,653 Capital 15.0% 499 821 1,144 1,467 1,790 2,112 2,435

15.9% 471 770 1,068 1,367 1,665 1,964 2,262 17.0% 445 720 995 1,270 1,545 1,820 2,095 18.0% 424 680 936 1,192 1,448 1,704 1,960 19.0% 406 645 885 1,124 1,363 1,603 1,842 20.0% 389 614 839 1,064 1,289 1,514 1,739

SG&A 2006-onward

Enterprise Value - SG&A 2006-onward & COGS 2006-onward

644.21 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0%91.0% (546) (248) 51 349 648 946 1,244

COGS 90.0% (249) 49 347 646 944 1,243 1,541 2006- 89.0% 47 346 644 943 1,241 1,540 1,838 onward 88.0% 344 643 941 1,239 1,538 1,836 2,135

87.0% 641 939 1,238 1,536 1,835 2,133 2,432 86.0% 938 1,236 1,535 1,833 2,131 2,430 2,728 85.0% 1,234 1,533 1,831 2,130 2,428 2,727 3,025

SG&A 2006-onward

Multiple Analysis

On the surface, Lenovo’s acquisition of IBM PC seems prohibitively expensive at a

multiple of 30.1x 2005E EBITDA. However, taking into account the expected cost savings from

COGS and SG&A the multiple is actually very reasonable. To calculate the 2005E pro forma

EBITDA at the time of the transaction, we added 40% of the expected COGS and SG&A costs

saving, US$103 million and US$133 million, respectively. However, we ignored the “one-off”

warranty savings that increases 2005E and 2006E EBITDA quite significantly. This adjusted

multiple analysis results in a EV / EBITDA multiple of a mere 4.5x. Please see Table K below for

the details of the calculation.



Table K: Multiple analysis

MULTIPLE ANALYSIS

US$ millionEnterprise Value (excl. one-off warranty savings) 1,250 Actual 2005E EBITDA 41 plus 40% est. total COGS savings 103 (=40%*2.7%*2005E Net Revenue) plus 40% est. SG&A savings 133 (=40%*3.5%*2005E Net Revenue)Pro forma 2005E EBITDA 278

EV / Actual 2005E EBITDA 30.1xEV / Pro forma 2005E EBITDA 4.5x

Of course, this analysis assumes that at least 40% of the cost savings will materialize and

that the buyers pay for them upfront. Nonetheless, this analysis is important to fully understand

the thinking of the private equity players at the time of the transaction. According to Winston Wu

of TPG: “At face value, the EBITDA multiple seemed excessive. However, after incorporating the

run-rate synergies and cost savings at a discount, the multiple looked very attractive, in the mid-

single digits.”48 Indeed, this multiple was a significant discount to the publicly traded comparable

companies at the time of the transaction. Please see appendix for the common stock comparison

done at the time of the transaction.49

Conclusion

Though it is too early in the execution process to make a definitive judgment about the

ultimate outcome of the transaction, Lenovo’s acquisition of IBM’s PC division clearly is on the

path to success. As with any ground-breaking effort, the undertaking is rife with significant risks.

As detailed in this paper, Lenovo increased odds of success by carefully negotiating a deal to

specifically address each of the key risks. In addition, based on reasonable cost saving

assumptions, they were able to negotiate a very attractive purchase price according to our analysis.

Western private equity firms played a crucial role in this process by helping to bridge the

significant cultural divide between Lenovo and IBM and by providing crucial financial and

48 Winston Wu 49 Source: Goldman Sachs Deal team



operational expertise. As a result of these collective efforts, Lenovo’s acquisition of IBM’s PC

division may come to be viewed as a watershed that not only forever changed Western views about

China’s economic ambitions and but also opened an era of significant cross border partnerships

that will fuel the continued economic integration of China and the West.



APPENDIX A Private Equity Firms Texas Pacific Group Texas Pacific Group (TPG) is a leading global private equity investment firm. It currently manages over US$13 bn of committed equity capital. Its portfolio of companies generates over US$35 bn in revenues and has over 500,000 employees. TPG is a leading global private equity investor in technology, with investments including MEMC Electronic Materials, ON Semiconductor, Seagate Technology, Business Objects, Conexant Semiconductor, Eutelsat, Isola, Network General, Paradyne Networks and Smart Modular. Other TPG investments have included Burger King, Continental Airlines, Del Monte Foods, Ducati Motorcycles and J. Crew. TPG is based in Fort Worth, Texas, San Francisco and London. General Atlantic Group General Atlantic Group is a leading global private equity firm focused on investing in companies providing information technology or using information technology to drive growth. Investment entities affiliated with General Atlantic LLC make investments on an arm’s length basis in portfolio companies. General Atlantic’s current investments in China include Vimicro and Digital China. The firm was founded in 1980 and has about US$8 bn in capital under management. General Atlantic has invested in over 140 companies and has current holdings in over 50 companies, of which almost half are based outside of the US. General Atlantic Group has offices in Greenwich, New York, Palo Alto, Washington, DC, London, Düsseldorf, Singapore, Tokyo, Mumbai, Hong Kong and São Paulo. Newbridge Capital Group Newbridge Capital Group is one of Asia’s leading private equity investment firms with US$1.7 bn of capital under management. Founded in 1994 by Texas Pacific Group and Blum Capital Partners, Newbridge Capital Group was one of the first private equity firms dedicated to Asian investments. The firm has offices in Hong Kong, San Francisco, Shanghai, Tokyo, Seoul, Mumbai and Melbourne. Newbridge Capital Group has made significant investments in such companies as Hanaro Telecom, Japan Telecom, Korea First Bank, Matrix Laboratories and Shenzhen Development Bank. Source: CSFB Research50

50 Jeannie Cheung, et al., Lenovo Group: Powering Up, April 12, 2005.



APPENDIX B Historical and Projected Financials INCOME STATEMENT

2001 2002 2003 2004 2005 2006 2007 2008 2009

NET REVENUE External Sales 9,745 8,962 9,288 10,000 9,263 9,392 9,524 9,657 9,792 Sales to IBM 333 275 278 278 271 305 310 314 318 Total Net Revenue 10,078 9,237 9,566 10,278 9,534 9,698 9,833 9,971 10,111 %growth -8.3% 3.6% 7.4% -7.2% 1.7% 1.4% 1.4% 1.4%

COST OF GOODS SOLD EXTERNAL Sales 8,815 8,066 8,327 8,965 8,289.94 8,359.04 8,380.83 8,449.87 8,519.21 %revenue 90.5% 90.0% 89.7% 89.7% 89.5% 89.0% 88.0% 87.5% 87.0% Sales to IBM 333 275 278 278 257.50 274.84 272.50 274.74 277.00 %revenue 100.0% 100.0% 100.0% 100.0% 95.0% 90.0% 88.0% 87.5% 87.0%Total Cost of Goods Sold 9,148 8,341 8,605 9,243 8,547 8,634 8,653 8,725 8,796 %revenue 90.8% 90.3% 90.0% 89.9% 89.7% 89.0% 88.0% 87.5% 87.0%

GROSS PROFIT EXTERNAL Sales 930 896 961 1,035 973 1,033 1,143 1,207 1,273 %margin 9.5% 10.0% 10.3% 10.3% 10.5% 11.0% 12.0% 12.5% 13.0% Sales to IBM - - - - 14 31 37 39 41 %margin 0.0% 0.0% 0.0% 0.0% 5.0% 10.0% 12.0% 12.5% 13.0%Total Gross Profit 930 896 961 1,035 986 1,064 1,180 1,246 1,314 %margin 9.2% 9.7% 10.0% 10.1% 10.3% 11.0% 12.0% 12.5% 13.0%

EXPENSESSG&A 1,201 1,038 1,013 1,059 982 873 787 698 688 %sales 11.9% 11.2% 10.6% 10.3% 10.3% 9.0% 8.0% 7.0% 6.8%R&D 179 138 139 135 125 128 129 131 133 %sales 1.8% 1.5% 1.5% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3%IP Income (134) (118) (75) (68) (63) (64) (65) (65) (66) %sales -1.3% -1.3% -0.8% -0.7% -0.7% -0.7% -0.7% -0.7% -0.7%Other (income)/expense (23) (94) 1 (0) - - - - - Total Expenses 1,223 964 1,078 1,126 1,045 937 851 764 754

WARRANTY SAVINGS 324 235 - - - %external net revenue 3.5% 2.5% 0.0% 0.0% 0.0%

EBIT (Incl. warranty savings) (293) (68) (117) (91) 266 362 329 483 560

EBITDA (incl. warranty savings) (186) 18 (56) 9 366 482 459 618 705 EBITDA (excl. warranty savings) (186) 18 (56) 9 41 247 459 618 705

Actual ProjectedYE December 31,

Source: Company filings, analyst research and authors’ assumptions



APPENDIX C Common Stock Comparison done at the time of the transaction

Source: Goldman Sachs deal team

Case Study on Lenovo and IBM

Documents