China Tackles Marginalized PC

San Jose, Calif. — It would be a mistake to take last week's sale of IBM Corp.'s PC division to Lenovo, China's biggest computer maker, as the final sign that the PC is dead. The box, in fact, is very much alive — just not for the company that helped launch it.

In these early days of the transition to digital pictures, music and video, there's plenty of elbow room to sort out how the home PC will evolve into a media server or get embedded into devices like gateway/routers and TVs. But in an industry increasingly driven by cost, IBM once again made a choice not to take part.

Under CEO Sam Palmisano, IBM had already spun off its disk drive business and jettisoned storage adapter cards and merchant communications chips to concentrate on services, software and servers.

The PC business is about high volumes, low margins and off-the-shelf technologies. That just didn't fit with IBM's high-margin systems business. "IBM is an innovation company," Palmisano wrote in a memo to employees explaining the sale. And, once again, Big Blue is circling the wagons around its core innovations.

IBM has effectively said it does not see a breakout opportunity in PCs, hard drives or comms chips. Although the company helped codify the category with its IBM PC in 1981, it is now a distant third in sales to Dell and Hewlett-Packard.The $1.75 billion Lenovo deal is also a tacit admission that IBM's strategy of focusing on the relatively high-growth notebook market has not made enough of a difference. No doubt this will be one of the greatest losses of the sale, given that its ThinkPads showed world-class design skills and made for a high-profile brand.

The new, post-PC IBM loses nearly $11 billion from its top line, but probably a negligible $10 million from its bottom line. Gross margins are expected to creep up 1 percent. The stock market responded on the day the deal was announced by nudging IBM's stock up 55 cents. "For a company that just jettisoned $11 billion in revenues, that's pretty good. The market is saying it's in favor of this," said Martin Reynolds, a senior Gartner Dataquest analyst.

For Lenovo, the deal is a historic shot at the big time. The company has come a long way since 1988, when it started life as Legend, a PC distributor in China. Today, Lenovo is China's largest PC maker, but it has almost no business outside China. The deal with IBM buys it some 8 million worldwide customers, crack system design teams in the United States and Japan and a top-notch logo. IBM will retain 18.9 percent equity in the venture and Lenovo will move its headquarters to New York. "We're seeing the emergence of the first Chinese-owned world-class technology brand," said Dataquest's Reynolds.

But Lenovo must retain IBM's core conservative business customers while finding a way to radically grow that business. That implies resurrecting IBM's long-abandoned consumer PC business. As a first step, the venture plans a phased, five-year approach as it shifts from the IBM to the new Lenovo brand.

Employees are the wild cards in this deal. The culture shock may be intense for the average IBMer who wakes up to find he or she is now part of a Chinese company that wants to push its desktop business into fast-forward mode. One report from the trenches last week said that people were "freaking out" at the prospect.Fresh spark for some

On the other hand, said Reynolds, some employees may find it rejuvenating to go to bed as the black sheep of Armonk, N.Y., and awaken as Beijing's golden child. A new, more aggressive charter and flexibility under Lenovo might be bracing for many. No doubt many desktop engineers will welcome the challenge to design a truly hot consumer PC.

Outwardly, the new company will retain an IBM look and feel — for a while anyway. No layoffs, pay cuts or changes in facilities are expected while the new venture gets its feet on the ground. But, said Reynolds, "The new company will accept low profits, but there has to be growth. If the growth is not there, there will be changes and cuts."

CEO Palmisano explained the sale by saying that the PC business is now all about scale. True. But that's not to say innovation and profits don't count. The PC is not dead just because one of its progenitors has dumped it. The world's largest chip and software companies are proof of how much life is left in this box. Intel and Microsoft will continue to drive much of this innovation, and thus reap the lion's share of the sector's profits.

Innovation comes harder for top-tier OEMs weighed down with supply chains moving heavy volumes of products and negotiating complex relationships with suppliers and channels. Indeed, the largest OEMs are becoming relatively slow and risk-averse. More and more, innovation may come from partnerships between alternative brands (say, Wal-Mart or Verizon), technology suppliers and no-name design firms — but that's another story.

In the short term, analysts foresee a lull between hardware refresh cycles that could be the first test for the new competitive landscape IBM created last week."We expect a slowdown in the PC market in 2006. It will be quite brutal, with wholesale cost cutting," Reynolds said. "By getting out now, IBM gets a better price for the division and the new company gets a chance to get its feet on the ground before this hits."

In the long term, both China and the PC have a long runway.