Why Lenovo paid $2.3 billion for IBM’s low-end server unit

Why Lenovo paid $2.3 billion for IBM’s low-end server unit

By Miguel Helft, senior writer January 24, 2014: 11:37 AM ET

Here’s a hint: Apple and Samsung should be nervous.

FORTUNE — In this game of chicken, it looks like IBM blinked.

The Armonk, N.Y.-based technology company (IBM) has wanted to unload its low-end, x86 server business for some time. Early last year, it conducted serious negotiations with the most likely buyer, Lenovo, the Beijing-based company that purchased its personal computer business in 2005. News of an impending deal, presumably leaked by IBM, suggested that the unit would fetchnorth of $4 billion. But it was premature: Lenovo balked at the steep price and walked away.

On Thursday, the companies announced that they finally had a deal. Lenovo will pay $2.3 billion for IBM’s business, which brings in approximately $4.6 billion in revenue annually. Some 7,500 IBM employees will join Lenovo.

The news comes just two days after IBM said during its fourth-quarter earnings report that its hardware business was declining faster than expected. While the decision to seal the deal with Lenovo likely preceded the report, it’s clear that IBM understood that it was holding on to an asset whose value would only decline over time. It wisely took the $2.3 billion, even though it was a much smaller sum than what it had asked a year earlier.

The deal makes plenty of sense for Lenovo, too, as well as its investors, which sent the company’s U.S. shares up by more than 3% on the news. The Chinese company has been killing it in the PC business for years. A little over six months ago, it became No. 1 in the industry, edging out Hewlett-Packard (HPQ). Lenovo is also the only major PC vendor that has managed to hold steady as the PC market experiences its worst declines in history. The company has staked its success on a strategy of diversification (in both product and geography), scale, and wafer-thin margins. Oh, and flawless execution.

As Fortune explained in a feature story last year, Lenovo’s ultimate goal is to leverage its dominant position in PCs to challenge Apple (AAPL) and Samsung in mobile.

So how does this deal further those ambitions? First, it significantly strengthens Lenovo’s position in low-end servers, a business that has a lot of synergies with PCs with regard to development and manufacturing. With IBM’s unit, Lenovo will go from No. 6 to No. 3 in the business of selling servers to corporate data centers. “It grows our business by almost a factor of 10,” Peter Hortensius, a senior vice president at Lenovo, said in a conference call with reporters.

What’s more, while low-end servers were a low-margin business for IBM, they represent a high-margin business for Lenovo, which has often prioritized market share over profits and undercut rivals like Dell and HP on price.

A boost in overall profit margins could give the Chinese company the breathing room it needs to invest more heavily in its mobile business, which is still young but growing quickly. In the third quarter, Lenovo, which entered the smartphone market only a little more than two years ago, became the No. 3 seller worldwide, on the strength of its business in China and other developing markets. While Lenovo’s 5.1% share of the global market remains far behind Apple’s 12.1% share and Samsung’s 32.1% share, the performance is impressive.

“We’re very excited by this acquisition,” Hortensius said. “It’s the logical next step for us.”

The major question now is whether the deal will clear regulatory approval, including a likely national security review. History suggests it will: Unlike many Chinese companies, Lenovo largely operates by Western standards of transparency and openness. It sells tens of thousands of PCs to federal agencies, and it has been cleared to buy American companies or units of American companies on multiple occasions. The most significant of those was Lenovo’s 2005 acquisition of IBM’s PC business, a deal that began the transformation of a successful Chinese company into a global powerhouse. Hortensius, who helped negotiate that deal on behalf of IBM and then joined Lenovo, said he expects the deal to close in six to nine months.