Professional Documents
Culture Documents
By
John Ackerly
Måns Larsson
Cambridge, MA
December 2005
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.
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.
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.
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.
PriceWaterhouseCoopers, “Report of Independent Registered Public Accounting Firm To the Stockholders and
16
17
Ibid.
18
“Champ or chump?,” The Economist, December 9, 2004,
19
Ibid.
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.
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.
A.M. Sacconaghi, et al., “IBM: PC Business Sale Immaterial But Risks ‘Growth Gift’ to Rivals,” Bernstein
24
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.
28
Winston Wu, interview by authors, December 6 2005.
29
Winston Wu, interview by authors, December 6 2005.
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
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.
Source: Lenovo32
32
Lenovo, Proposed Issue of Unlisted Convertible Preferred Shares and Unlisted Warrants, March 30, 2005, p. 13.
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
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.
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.
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.
The discussion below highlights the key drivers of our base case valuation analysis:
Sales to IBM
Volume 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%
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.
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
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.
Actual Projected
2004 2005 2006 2007 2008 2009
WARRANTY SAVINGS
As % External Net Revenue N.A. 3.5% 2.5% 0.0% 0.0% 0.0%
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.
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.
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
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.
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.
Actual Projected
2004 2005 2006 2007 2008 2009
EBIAT CALCULATION
EBIT (91) 266 362 329 483 560
less Taxes (167) (78) (98) (85) (121) (140)
EBIAT (258) 187 264 243 362 420
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).
COGS 2006-onward
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
SG&A 2006-onward
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
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
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$133 million, respectively. However, we ignored the “one-off”
warranty savings that increases 2005E and 2006E EBITDA quite significantly. This adjusted
multiple analysis results in a EV / EBITDA multiple of a mere 4.5x. Please see Table K below for
the details of the calculation.
MULTIPLE ANALYSIS
US$ million
Enterprise Value (excl. one-off warranty savings) 1,250
Actual 2005E EBITDA 41
103 (=40%*2.7%*2005E Net Revenue)
plus 40% est. total COGS savings plus 40% est. SG&A savings
Pro forma 2005E EBITDA 133 (=40%*3.5%*2005E Net Revenue)
278
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
50
Jeannie Cheung, et al., Lenovo Group: Powering Up, April 12, 2005.
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%
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%
EXPENSES
SG&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
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