Security Concerns Put IBM / Lenovo x86 Server Deal In Limbo

| About: International Business (IBM)


News has emerged that the latest deal between IBM and Lenovo is in limbo following the U.S. government's security concerns over IBM's x86 servers.

The servers are extensively used in the country's communications networks and in data centers that support the Pentagon's computer networks.

IBM and Lenovo faced a similar situation in 2005 when Lenovo bought IBM's personal computer business.

IBM (NYSE:IBM) announced the sale of its x-86 server business to Lenovo in January this year. According to the deal, Lenovo was to pay approximately $2.3 billion, including $2.07 billion in cash, and the rest in Lenovo stock. In return, Lenovo is expected to acquire IBM servers that use x86 processors, including BladeCenter and Flex System blade-style servers - slim devices that slide into racks - along with the associated switches. Furthermore, Lenovo and IBM were also expected to enter into a strategic partnership that allowed Lenovo to resell IBM's cloud computing and storage systems as well as some of its software. About 7,500 IBM employees were expected to join Lenovo to take over existing support contracts as well as future sales.

However, news has emerged that the deal is in limbo following the U.S. government's security concerns over IBM's x86 servers, which are extensively used in the country's communications networks and in data centers that support the Pentagon's computer networks. [1] In this note, we will discuss the ramifications if the deal falls through.

Losses To Mount If Deal Falls Through

According to our estimates, the server and microelectronics division forms a minuscule part of IBM's stock value. The primary reason for this is that the system and technology division, which includes the server, storage and microelectronics division, has been reporting losses. A significant decrease in sales has severely strained margins, resulting in operational losses for IBM in 2013. For 2013, this division reported $14.37 billion in revenues, and a pre-tax loss of $507 million. For the quarter ended in March, the company reported a pre-tax loss of $660 million for revenues of $2.39 billion. Considering the current trend, we expect that IBM will continue to report losses as its server business has lost market share over the past few quarters.

Precedence Suggests That The Deal Will Pass, Albeit With A Delay

IBM and Lenovo faced a similar situation in 2005, when Lenovo bought IBM's personal-computer business. Nevertheless, the Committee on Foreign Investment in the U.S. (CFIUS), a panel that screens deals with possible national security implications, which initially objected to the sale of the PC business, ultimately cleared it. However, the U.S. military alerted department of defense to security incidents involving the PCs. Government officials are now concerned about the potential sale of part of the x86 portfolio as these are used as clusters of servers across many critical departments.

Both the companies involved in the deal state that x86 servers constitute every-day technology and are manufactured by other U.S. companies. Furthermore, a majority of the servers, including IBM's, are made in China and contain Chinese components. Therefore, the sale of the business should not be stopped on security concerns.

Despite the concerns, the deal is likely to get approved, people familiar with the matter said. IBM and Lenovo last month refiled their application for approval of the deal, according to Bloomberg. CFIUS is mainly concerned about maintenance of the servers, which can range from remotely updating software to the physical upkeep of the hardware by a technician. CFIUS believes that once contracts with IBM lapse, the maintenance might be taken up by Lenovo, which it fears can leave the machines vulnerable to attacks from Chinese agents. With such concerns voiced by CFIUS, the possibility remains that the U.S. government could stop buying x86 servers from Lenovo.

While a Lenovo spokesman said the deal remains on track to close by year-end, we will continue to closely monitor it for any new updates. At present, we have a $230 Trefis price estimate for IBM which is about 30% higher than the current market price.

Disclosure: No positions.

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