Lack Of IBM-Lenovo Deal Implies Rapid Change In Server Market

| About: International Business (IBM)

The negotiations between IBM (NYSE:IBM) and Lenovo (OTCPK:LNVGY), over a possible sale of IBM's server business have reportedly halted. Lenovo doesn't compete directly with IBM and with the previous successful sale of its PC business to Lenovo, there were high hopes of the deal going through. And although the talks have ended that doesn't mean that the option is off the table. We believed that IBM's (and Lenovo's) move made perfect sense because proprietary hardware and big silicon is a business model on the road to obsolescence.

Both Quanta Computers (OTC:QUCPY) and Compal Electronics (OTC:CMPCY), two of the leading contract notebook manufacturers, are moving into servers, further driving commodity pricing into Open Stack compliant hardware. IBM's hardware operations continue to disappoint, causing the replacement of the division chief and making the case for the sale of some, if not all, of the components of its servers business even stronger.

Earnings Miss

IBM released its quarterly results last month in which it missed earnings estimates, despite lower tax rates. This was Big Blue's first miss in nearly eight years. Quarterly revenues dropped 5.1% from last year to $23.41 billion missing markets expectations by $1.28 billion. This translated into an EPS of $3.00, 5 cents below estimates and if it hadn't been for the lower taxes, then IBM would have missed the earnings estimates by $0.34 per share. The poor performance was blamed on the sales force who failed to close some of significant hardware and software deals.

Hardware Woes

The company's hardware division reported a 17% drop in sales to $3.11 billion. Thereafter, the company has reassigned its Hardware unit boss Rod Adkins to Senior VP of Corporate Strategy and he is being replaced by Tom Rosamilia from Corporate Strategy.

Servers in Transition

IBM's x86 servers serve the low end of the market and the resultant thin margins are of little use to it, eerily similar to the situation its PC business was in back in 2004 before selling it off to Lenovo. But, the comparisons really end there as the server market is undergoing another level of commodification and virtualization that makes this a more treacherous play for the growth-hungry Lenovo to make.

Though Lenovo is aiming to ramp up its competition with its rivals Hewlett-Packard (NYSE:HPQ) and Dell (NASDAQ:DELL), particularly in the emerging markets, the x86 server market is coming under serious threat from low-power ARM (NASDAQ:ARMH) microservers like those of Calxeda. The early reviews of these new ARM-based servers have been very competitive with Intel's (NASDAQ:INTC) offerings in terms of performance at distributed tasks while consuming significantly less power. It's another variation on the battle between small numbers of powerful CPU cores versus huge numbers of smaller, less powerful cores. Anandtech had an excellent review of the Calxeda microservers recently that highlight this.

Lenovo has to be aware of this and has looked at the possibility of what Intel's Bay Trail ATOM CPUs will bring to the table and is having valuation issues in adapting IBM's current business to the future. At this point AMD (NYSE:AMD) has nothing competitive in this space which is why it is developing ARM Cortex A50 series APUs for its SeaMicro microserver division. Unless the firm has some special plans for Jaguar that it is holding very close to its vest, we don't see AMD competitive in the x86 in the server business at this time.

Lenovo Knows its Business

While everyone else is licking their wounds in the PC business, Lenovo has been growing; pulling market share from Hewlett-Packard and practically forcing Dell off the NASDAQ. Moreover, it seems that every market it attacks it wins market share in and quickly. The latest is smartphones and tablets. So, if Lenovo is balking at IBM's asking price given their history, Lenovo is telling the industry the changes within the industry are coming quicker than we may be expecting.

According to recent news reports by CRN, IBM valued the business at around $5.5 billion. Bloomberg thinks it is worth between $2.5 billion and $4.5 billion. The talks have broken down over valuation. Even at $2.5 billion, this is a big deal for Lenovo with its $9 billion market cap.

But, regardless of where the market is heading, Lenovo's impressive penetration in emerging markets and China is a natural fit to buy this business and extend its already impressive brand regionally.

Bigger Fool Problem

Earlier, IBM got rid of the commoditized PC unit at the right time for both it and Lenovo and is now trying to do something similar with the server business, which at its current asking price is good for IBM but not for Lenovo. But IBM still continues to operate in a traditional way, selling hardware, software and computer systems while the world is moving quickly towards cloud computing and few have made any significant strides to pull market share from Amazon (NASDAQ:AMZN) in this rapidly commoditized market.

Everything Amazon touches is driven to its commodity limit and IBM shouldn't want any part of that either unless it is building SaaS solutions on top of that. Since IBM doesn't even reveal its revenues from cloud computing, although they were up 70% in Q1 year over year, we can only guess the numbers are not sterling. According to its own targets, the unit should be able to generate $7 billion in revenues by 2015.

This breakdown in talks was not going to make or break IBM but it will be a drag on earnings and overall margins until it occurs with value locked up in unproductive and depreciating assets. The money from the sale could and should be put to better use.

If we were new CEO Virginia M. Rometty we would be pushing this sale almost regardless of price to extract as much value as possible. Until the company can repurpose these assets to raise operating income safely above dividend payout levels we cannot recommend buying with the market priced as it is and global growth slowing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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