Lenovo’s Bid to Become the Last Hardware Giant Standing

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While many tech giants are fleeing the hardware business, China’s Lenovo is embracing it. In a two-week span in late January and early February, IBM, Google and Sony sold off portions of their hardware businesses due to a challenging cost structure, thinning profit margins and the desire to focus on more lucrative areas.

In two of those three cases — Google’s unloading of Motorola Mobility and IBM dropping its low-end server business — the cast-offs were acquired by Lenovo. Although Lenovo seems to be betting on hardware, many are wondering if the sector is still a worthwhile business venture, as the Chinese tech giant and other hardware-centric companies such as Hewlett-Packard (HP) and Cisco Systems continue to deliver lackluster sales growth.

Lenovo announced on January 23 that it will pay $2.3 billion to buy IBM’s server business. The two companies have successfully negotiated similar deals before: In 2005, Lenovo purchased IBM’s PC business, and last year the Chinese firm usurped HP as the world’s largest PC maker, according to research firms Gartner and IDC. Meanwhile, on January 29, Lenovo revealed that it paid $2.9 billion for the Motorola smartphone business that Google acquired for $12.5 billion in 2012. (In the intervening time period, the search giant sold off parts of Motorola, including a home set-top box business, and will retain only Motorola patents following the Lenovo deal.)

Sony said on February 6 that it was selling the Vaio brand to Japan Industrial Partners and will discontinue the manufacturing, development and design of PCs after the spring 2014 lineup is launched. The downturn for hardware at Sony isn’t just limited to computers: The firm also announced that it is restructuring its TV business and cutting 5,000 jobs.

Coming on the heels of such announcements, Lenovo is firmly establishing itself as an outlier. “Hardware is a weird market to double down on,” says Wharton management professor Michael Useem, though he also notes that Lenovo “has figured out how to manufacture [hardware] as cost efficiently as anyone out there.”

“Hardware is a weird market to double down on.” –Michael Useem

But is that enough when the industry is rapidly moving away from the traditional model of computer servers and PCs? Cloud computing offerings like Amazon Web Services provide infrastructure on demand, much like a common utility, freeing corporations from having to purchase large scale hardware systems for their own data centers. Thanks to innovations in both hardware and software, more computing power can now be crammed into less hardware. And consumers and businesses alike are increasingly turning to tablets or mobile phones where they may have previously used PCs.

IBM’s fourth quarter systems and technology sales — which include servers, mainframes and storage systems — fell 26% from the same quarter a year ago. Hewlett-Packard’s fiscal first quarter hardware sales, reported February 20, were up just 4% from a year ago, with CEO Meg Whitman saying that the PC industry may have bottomed out. For Cisco’s fiscal second quarter, reported February 12, the company said its core switching and routing sales fell 12% and 11%, respectively, from a year ago.

For Lenovo to succeed where others have faltered, it will need to develop a focused strategy to maximize efficiency and contain costs, Wharton experts say. The hardware business depends on scale, and it is difficult for diversified companies like Google, IBM and Sony to match the supply chain efficiencies of giants like Lenovo and South Korea-based Samsung. “The hardware business demands different capabilities and just isn’t glamorous,” notes Wharton emeritus management professor Lawrence Hrebiniak. “Hardware is about low costs, design, computer aided drafting and manufacturing. Software is just more fun.”

But Lenovo now faces the challenge of integrating two disparate acquisitions, identifying the weaknesses in each and determining how to make them profitable, says Wharton management professor Saikat Chaudhuri.

“I see where Lenovo is headed strategically, but pulling the integration off won’t be easy. The server part will be easier since Lenovo can just sell servers and PCs to the enterprise sector,” Chaudhuri points out. “For the Motorola business, Lenovo will need more effort and product development. Google couldn’t do anything with it.”

Lenovo’s Game Plan

In an earnings conference call on February 12, Lenovo CEO Yang Yuanqing addressed the company’s plans to integrate IBM’s server business, as well as Motorola. Lenovo has become the third-ranked smartphone maker in the world by becoming a player in emerging markets.

“We will fully leverage our strength in supply chain to bring down the costs, and are confident we can turn the server business into a more profitable business than PCs,” said Yuanqing, who made similar comments about Motorola, a brand Lenovo plans to re-introduce to China, North America and Latin America. Yuanqing added that he isn’t currently planning to cut the IBM or Motorola workforce because the company wants to gain the engineering and research and development talent as part of the acquisitions.

“For the Motorola business, Lenovo will need more effort and product development. Google couldn’t do anything with it.” –Saikat Chaudhuri

“The Motorola deal gives us entrance to the U.S., Latin America and other mature markets. It gives us the brand we need … [and the] very strong carrier relationships we need. It will give us a very good talent pool,” noted Yuanqing. “Meanwhile, at Lenovo we have a much more efficient operation platform and much more efficient manufacturing facilities. We are definitely confident that we can improve the profitability with the Motorola business.”

According to Hrebiniak, Lenovo can justify both deals simply by becoming a leading server and smartphone maker in its home base in China. “Lenovo is going to integrate these acquisitions and focus on China,” Hrebiniak notes. “Lenovo can pick up a lot of business [there] and then increase the global competition.”

Lenovo’s strategy to date has been to protect its market share in developed markets like the U.S. and China while growing in emerging economies such as Latin America. That strategy has allowed Lenovo to become one of the few PC vendors to navigate the so-called post-PC era in which mobile devices like tablets and smartphones dominate computing.

No Easy Out

One primary reason companies are exiting the hardware business is that it’s increasingly difficult to squeeze efficiencies out of the supply chain. “There is a broader feeling that there is room in the supply chain for more efficiency, but it’s increasingly hard to do,” says Wharton management professor David Hsu.

For instance, wages in China will rise as the middle class develops. Better working conditions will also pinch costs. “From a pure cost of production [standpoint], Lenovo saves [on expenses] because it’s in China, but [eventually] manufacturing will move to other places,” Hsu states, adding that Lenovo is likely to eventually adopt a design and manufacturing process similar to Apple’s, where products are designed at the company’s home base but ultimately are made elsewhere.

Indeed, even companies like Hon Hai Precision’s Foxconn unit, which makes the iPhone and iPad, are having a more difficult time preserving already thin profit margins, say analysts. Yet there are still opportunities for efficiency: Hsu predicts that Lenovo will likely look to produce more software that it can integrate with its hardware designs, much the way Apple and Samsung do.

Hrebiniak adds that he expects Lenovo to find adjacent markets and expand once it integrates the server and smartphone businesses. “Lenovo is really focused on vertical integration, getting software into the hardware and then integrating and coordinating.”

“There’s a broader feeling that there is room in the supply chain for more efficiency, but it’s increasingly hard to do.” –David Hsu

According to Chaudhuri, Lenovo’s move to expand into more hardware sectors has to be part of a larger plan to move up the value chain. “Hardware fits with Lenovo because it can push costs down, but it’s all getting commoditized,” he points out. “Unless Lenovo or other hardware companies build a strong enough brand around products, they will have trouble moving into higher-end services.”

But integration isn’t easy. Indeed, Google was unsuccessful at using the Motorola purchase to replicate the seamless ecosystem of software and hardware that Apple has built up over the years. Microsoft recently acquired Nokia’s smartphone business in an attempt to better integrate the company’s hardware and software.

“You can throw Microsoft and Nokia into the same category as Google and Motorola,” says Useem. “These companies are looking at adjacencies to what they know. There’s an inner logic to it, but it can be failing logic, too. The jury is out.”

Chaudhuri adds that Microsoft acquired Nokia as a last stand to make a move in the mobile market. Thanks to cash cows like Windows and Office, Microsoft has the resources to make a few mistakes along the way — but Lenovo has no such cushion, Chaudhuri notes.

For now, Chaudhuri credits Lenovo for making bold moves and being one of the few companies [embracing] the commoditized hardware business. “Strategically, these acquisitions aren’t wrong, but Lenovo has a lot to do with the implementation to make them work,” says Chaudhuri. “Lenovo had opportunities to snap up these assets and took them.”

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One Comment So Far

John Mulhern III

One of Lenovo’s advantages in this area is their seemingly deeply held interest in at least mildly differentiated hardware and belief that they can make money selling it. This contrasts with almost all their competitors who are desperately trying do decrease the percentage of their total sales that come from hardware. They had been shopping for the IBM server business for a while, but the Motorola Mobility purchase looks more like one that they felt they couldn’t let get away.

Now, all they have to do is execute …