Lenovo Group Ltd. appears to have turned around International Business Machines Corp.'s old PC division faster than a computer can reboot. Maybe the timing has something to do with it.
In April, its last month as a unit of IBM, the personal-computer operation recorded an operating loss of $149 million. Lenovo took over the business in May, and it posted an operating profit of about $33 million for May and June combined.
The turnabout, revealed in Lenovo's earnings this month, sparked an 11 percent jump in Lenovo shares on the Hong Kong Stock Exchange on Aug. 11 and prompted several financial analysts to upgrade their view on the stock.
At first glance, freeing the PC division from IBM seems to have worked wonders for its profitability and vindicated the acquisition. Lenovo made a splash late last year as a Chinese company cutting a high-profile deal with a U.S. icon. At the time, however, the computing industry questioned how Lenovo would revive a PC operation that had posted a long string of losses under IBM.
Headlines to the contrary, that question has yet to be resolved, and some analysts are cautioning investors not to overlook a crucial data bite: Results from the slowest sales month of the quarter fell to IBM rather than Lenovo. Indeed, the first month of every quarter typically has produced the least revenue for the division.
Lenovo executives gave no guidance about the sustainability of the turnaround when they reported earnings on Aug. 10, citing Hong Kong exchange rules restricting the discussion of expectations. Mary Ma, Lenovo's chief financial officer, notes the timing issue -- but also ticks off other reasons for the operation's swing to profit, including freedom from IBM expenses, the new ability to sell PCs to other units of IBM above cost and the shedding of warranty liabilities, which were kept by IBM.
"The number we have is a real number -- a true number of an independent commercial entity doing business," Ma said.
Still, the factors cited by Ma can't explain the breadth of the improvement without bringing the timing issue back into play. For example, being able to sell PCs to IBM, the PC operation's largest customer, for a profit rather than at cost would have added at most about $4 million combined for May and June, based on a back-of-the-envelope estimate of $80 million in sales to IBM and a 5 percent profit margin.
In its earnings report, Lenovo also announced $10 million in cost savings from supply-chain efficiencies. Analyst Matthew Wilkins at iSuppli Corp. in El Segundo, Calif., estimated that Intel Corp., for instance, has cut the cost of microprocessors by 1 percent for the former IBM division. When the unit was part of IBM, he said, it received less-favorable pricing because IBM has a semiconductor division that competes with Intel.
Ma said the company always tries to build closer relationships with suppliers, but she declined to talk about specific pricing.
She also cautioned that neither managers nor investors can directly compare "before" and "after" results after the PC-unit purchase, because of accounting differences in the United States, where the IBM unit was based, and Hong Kong, where Lenovo's stock is traded. (Lenovo now is based in Purchase, N.Y., but it derives most of its revenue outside the United States.) For instance, Lenovo records revenue more conservatively than did the IBM unit -- when payments are received rather than when a PC is shipped. Lenovo's financial reporting also is held up as a model in China, where many companies' books are opaque.
And because costs such as warranty payments vary by quarter, it is difficult for Lenovo to precisely gauge the impact of lower warranty liabilities. Johnny Chan, an analyst at J.P. Morgan in Hong Kong, estimated that IBM's PC division paid out the equivalent of 7 percent of revenue for warranties, while Lenovo is paying only about 4.5 percent. Based on that estimate and the revenue attributable to the old IBM division in May and June, the savings would have been about $40 million.
Lenovo's other challenges, apart from the difficulties of blending different corporate and national cultures, include overcoming language barriers and gradually substituting IBM-branded products with its own name. Its key strategic dilemma is how to bring the IBM operations into the black while maintaining as many of that operation's customers as it can. The former IBM unit's revenue was down 18 percent in the latest quarter from a year earlier, Chan estimated.
Over time, Lenovo hopes to lure more institutional investors and eventually list in the United States. That might be difficult for the next few quarters, when the company is unable to provide comparable results, Ma acknowledged.
"Shareholders have been asking a lot of questions, but they appreciate the situation," she said. "Well, I would say they understand it."
One longtime shareholder in Lenovo is Mark Headley, portfolio manager at Matthews International Capital Management LLC in San Francisco. His company's funds have owned Lenovo shares for more than five years, and Headley said they acquired more shares when Lenovo's share price tumbled in the weeks after the IBM deal was announced. Its largest Lenovo holding is in the Matthews Pacific Tiger Fund, which owned about 93 million shares on March 31, the most recent reporting date, he said.
Headley said he realizes "a lot of things are going to be difficult to analyze for a while." He added, "I think you have to give management at least a year."