Until recently, it seemed only die-hard contrarians could love Lenovo Group Ltd. (0992.HK). Suffering from sagging profits, a massive battery-related notebook recall after one of its laptops caught fire at Los Angeles International Airport, and recently ousted from the Hang Seng Index of Hong Kong-listed blue chips, it seems like little has gone right since the Chinese group acquired International Business Machines Corp.’s (IBM) PC business last year. But slowly, Lenovo is beginning to win over fans, who say it has overcome the most difficult integration hurdles and could now be set to reap the benefits of what was initially scorned as an incompatible marriage.

Supporters now cite rising sales and improving profit margins as evidence the union is working. “The skepticism is changing,” said David Williams, chief executive of the California-based Williams Capital Advisors, referring to doubts the Chinese company could pull off an integration of global scale. Lenovo ranks as the third-biggest selling computer maker world-wide. “The company delivered on what those buyers were looking for; they wanted continuity, meaning not necessarily the same product, but innovation in products.”

Strategic Missteps Overcome
Among its strategic gaffes, critics say the company goofed by phasing out the IBM brand too quickly, even though the $1.25 billion deal in stock and cash secured the rights to its usage for up to five years. The IBM logo still appears on ThinkPad laptops and ThinkCenter desktops, but it was dropped from marketing and advertising campaigns. That was a branding blunder, the critics claim, and may have been partly to blame for a market-share decline in Europe, where the Lenovo name is lesser known than in China. During the second quarter, Lenovo’s European sales fell against the year-earlier period, even though the company managed to boost market share in Asia Pacific to 19.9% from 18.4%, and grew in line with the industry average in the U.S., according to estimates by International Data Corp.

Lenovo was also slow to stem loses at its U.S. operations, says Citigroup’s Kirk Yang. He said cost-cutting moves, such as a March announcement that 5% of its global work force would be pared, could have come sooner. Adding to its woes, Greenpeace this summer labeled Lenovo the worst among 14 major electronics companies in terms of toxic chemical use and recycling of environmentally harmful waste.

Lenovo’s Hong Kong-listed shares have fallen about 13% year-to-date, compared with a 12% gain in the Hang Seng Index. In the 21 months since announcing the IBM unit purchase, shares have moved in wide trading band and are now about 17% above pre-announcement levels.

Fiscal First Quarter Praised
Lenovo’s fan club is now waving the banner of sales and margins. In its fiscal first quarter, which ended June 30, revenue jumped 38% to $3.5 billion from a year earlier, while it also posted a slim net profit of $5 million after a $19 million restructuring charge.

Morgan Stanley analyst Viktor Ma says he upgraded his view on Lenovo to overweight from market-weight on signs the restructuring was beginning to bear fruit. Lenovo’s total PC shipments advanced 12% for the three months to June compared with a year earlier, outpacing industry-wide growth of just 9%. More importantly, Ma says, Lenovo stabilized margins and reduced operating loses in overseas markets. Its efforts in the Americas continue to be loss making, but operating profits improved one percentage point to negative 2.4% quarter on quarter. In the Europe, Middle East and Africa region, margins improved 1.1 percentage points, and verge on break-even.

Ma attributed a better product mix, improved design and other synergies from the merger with boosting overall gross profit margins to 14.3%, an increase of 0.3% from the previous quarter.

Ma thinks there could be further surprises as the restructuring picks up momentum. “We believe the restructuring plan will pay dividends in the next couple of quarters,” he said. Ma said he’s optimistic that Lenovo can continue to make gains in China, where it already has a commanding lead, having sold about 6.5 million computers last year. Lenovo has a 35% share of total PC shipments in China, trailed by local Chinese brand Founder at 13% and Dell at 10%, according to IDC estimates.

China, which ranks as Lenovo’s most profitable region, is also its fastest growing. Shipments there jumped 30% and revenue rose 32%, while shipments in the U.S. rose 6%. About 19 million computers were sold in China in 2005, compared with 64 million in the U.S., according to IDC estimates. “Overall I would be very optimistic, because if you look at them relative to other competitors, they have a foothold in two of the biggest markets in the world, China and the U.S.,” Williams said. “Lenovo is unique in being viewed as a domestic brand in China, where it’s known as Lianxiang, and in the U.S., where its notebooks sport the IBM brand”, he said.

Peering Around The Corner
In September, Merrill Lynch analyst Tien Yu Sieh lifted his recommendation on Lenovo to buy from neutral in a company report entitled “At the turning point.” “Our analysis shows that the company’s business model is highly leveraged to small changes in cost assumptions and that earnings growth could surprise the market to the upside if management can deliver on its potential,” said Sieh.

Sieh says he’s optimistic Lenovo’s new 3000 series of desktop and notebook computers can make inroads among small and medium-sized enterprises, segments traditionally dominated by Dell Inc. (DELL) and other big-brand names. Lenovo is also reaching out to retail consumers with an eye on product design. A plan to expand its sales partners by 30% in the U.S. should give Lenovo more marketing firepower at the point of decision making, Sieh added.

Market cynicism over the deal seemed justified when Lenovo reported a net profit of $22.2 million for the fiscal period ended March 2006, down 85% from the previous year. The acquisition of IBM’s PC business, completed in May 2005, transformed Lenovo overnight to third from ninth in global PC sales. Annual revenue ballooned more than three times to $13.3 billion.

“We believe the restructuring plan will pay dividends in the next couple of quarters..”

In December, Lenovo recruited former Dell executive William Amelio as CEO, replacing IBM’s Stephen Ward after just eight months on the job. Amelio spearheaded a $100 million restructuring plan, cut 1,000 workers from the global payroll for an annual saving of $250 million, and pushed to move the company headquarters to Raleigh N.C from Purchase N.Y.

Amelio has since tapped Dell for a half-dozen more executives to fill key management positions.

The Road Ahead
Although success is far from assured, Morgan Stanley’s Ma says he likes Lenovo’s chances in a head-to-head battle with global PC leader Dell in the fast-growing emerging markets. Lenovo’s reliance on traditional sales channels, which emphasize personal relationships and customer service, might be better suited to local consumers than the buy online mode of Dell’s direct-sales model.

“For low-income buyers in India or in rural China, there is no way they are going to fork out two years savings to buy a PC without actually feeling and touching and without having someone to show them how to use it first,” Ma said. In terms of PC sales in India, Lenovo and Dell are basically on equal footing, with market shares of 9% and 7% respectively, trailing market leader Hewlett-Packard Co. (HPQ) at 20% and domestic Indian brand HCL at 14%. Others aren’t so optimistic. Technology analyst Joseph Ho, of the Daiwa Institute of Research, has a negative rating on Lenovo owing to the overhang of IBM’s 15% stake in the company. The lock-up period for two-thirds of the shares expired in May. “The share supply can come onto the market at any time,” Ho said.

Among other obstacles, Ho says Lenovo will face continuing pressure to cut prices as it seeks to ramp up market share. Although the strategy is working in some regions, it ultimately looks doomed as more technology companies accelerate efforts to outsource production to China and India. In the long run, says Ho, the much-heralded low-cost manufacturing clout and home-turf advantage of Chinese companies will be undermined by a growing wave of imitators.

More Wary Than Downbeat
Ho believes Lenovo’s removal from the Hang Seng Index on Sept. 11 may mark an inauspicious start. Although index compiler Hang Seng Index Services gave no formal reason for Lenovo’s removal, substitutions are generally done to reflect changes in the regional economy and the shifting influence of industries. Losing its standing in the blue-chip index won’t hurt the share price or affect its operations, but it does signal a loss of prestige. More important, Ho says, Lenovo’s replacement, Taiwanese mobile-phone maker Foxconn International Holdings Ltd. (2038.HK), signals the growing influence of new players in China’s markets. Still, Ho says he’s more cautious than negative, adding he’ll be watching closely to see if Lenovo can continue to muster improved profit growth in coming quarters.