Lenovo's Plea for Patience

Disappointing earnings indicate the Chinese computer maker may be having more trouble than expected digesting IBM's PC division

by Arik Hesseldahl

For anyone who needed proof that it's tough to wring out a profit in the PC industry, China's Lenovo drove the point home on Nov. 9 with a report showing a 16% decline in fiscal first-quarter earnings.

Struggling to find its footing after its controversial $1.75 billion purchase of IBM's (IBM) unprofitable personal computer unit in 2004, Lenovo has been hammered by the same brutal pricing environment that has sapped profits at Dell (DELL) and Gateway (GTW), even as Hewlett-Packard (HPQ) has seen healthy growth.

Lenovo, the world's No. 3 PC maker, said profit fell to $38 million, below the $40 million analysts had forecast, while revenue rose a mere 1%, to $3.7 billion. What little growth there was came from notebooks, which increased 7%, and wireless phones, where sales grew 13%. Those gains were offset by a 6% drop in desktop sales and weakness in the Americas, where revenue slumped 9%.

"Reform is Painful"

The one major strength is at home. China now accounts for 39% of sales, and shipments there grew 25% over the previous year. "Asia is going gangbusters," says analyst Steve Clough of IDC. "America and Western Europe? Not so much."

Chairman Yang Yuanqing pleaded for patience from investors, saying, "Reform is a painful experience."

When it comes to investors, patience has a way of wearing thin. Lenovo's biggest job will be restructuring the IBM unit and cutting expenses at a business unit that has high fixed costs. "There's been a lot of shifting around of a lot of people, between Lenovo and what used to be part of IBM," Clough says.

Operating margins in the U.S. were. 2.2%, vs. 6.5% in China. Europe was even worse, with an operating margin of 0.2%. That's cause for concern, says analyst Brent Bracelin of Pacific Crest Securities in Portland, Ore. "Stable consistent success in China is encouraging, but more progress needs to be made in the Americas and in Europe, the Middle East, and Africa before a more constructive stance can be taken on the company," Bracelin says.

Inherited Problems

He's hopeful that restructuring efforts could position Lenovo to bounce back in the second half of the year. "I think Lenovo really bought a legacy business with business practices to match," Bracelin says. "For example, most computer companies have multiple suppliers for their components, but IBM didn't. There were a lot of components that came from single suppliers. That kind of thing is just unheard of today, and it gives you an idea of the kinds of problems that Lenovo inherited from IBM."

To help fix those problems, Lenovo has hired some high-profile executives from rivals, namely Dell. Among them: Gerry Smith, a former Dell vice-president based in Singapore, who's now running Lenovo's global supply chain. That followed the hiring of CEO William Amelio, former president of Dell's Asia Pacific operations.

The team has some big challenges ahead, particularly during the all-important holiday season. And like other PC makers, Lenovo won't be getting much help from Microsoft (MSFT), which has confirmed that Windows Vista, the next major upgrade of its operating system, will be released on Jan. 30, 2007. The software company has promised upgrades to anyone who buys a computer before the release date, but many consumers are expected to hold off on making purchases till Vista is out. With that in mind, IDC has forecast worldwide growth of 10.5% for 2006, down from 16% in 2005.

Hesseldahl is a reporter for BusinessWeek.com.