IBM will sell its PC division to China-based Lenovo Group and take a minority stake (18.9 percent) in the former rival Lenovo in a deal valued at $1.75 billion, the companies announced Tuesday.

  The two companies plan to form a complex joint venture that will make Lenovo the third-largest PC maker in the world, behind Dell and Hewlett-Packard, but still give IBM a hand in the PC business. The deal is expected to be completed in the second quarter.

  Under the deal, IBM will take an 18.9 percent stake in Lenovo. Lenovo will pay $1.25 billion for the IBM PC unit and assume debt, which will bring the total cost to $1.75 billion.

  Lenovo will pay roughly $650 million in cash and $600 million in securities.

  Based on both companies' 2003 sales figures, the joint venture will have an annual sales volume of 11.9 million units and revenue of $12 billion, increasing Lenovo's current PC business fourfold.

  Lenovo will be the preferred supplier of PCs to IBM and will be allowed to use the IBM brand for five years under an agreement that includes the "Think" brand. Big Blue has promised to support the PC maker with marketing and via its IBM corporate sales force.

  Lenovo is the ninth largest PC maker worldwide, according to the latest market share numbers compiled by Gartner.

  The combined venture will have roughly 10,000 IBM employees and 9,200 Lenovo employees. It will be headquartered in New York, with operations in Beijing and in Raleigh, N.C.

  Executives for both companies trumpeted the significance of the acquisition.

  "As Lenovo's founder, I am excited by this breakthrough in Lenovo's journey towards becoming an international company," said Chuanzhi Liu, current chairman of Lenovo.

  Key points of the deal
  Creates world's third-largest PC business.
  IBM to take 18.9 percent stake in Lenovo.
  Global business with worldwide reach and powerful brand name.
  Worldwide headquarters in New York.
  Transaction expected to be completed in second quarter.

  "Today's announcement further strengthens IBM's ability to capture the highest-value opportunities in a rapidly changing information technology industry," said Sam Palmisano, IBM chairman and chief executive officer.

  Stephen Ward, vice president of IBM's Personal Systems Group, will become CEO, while Yang Yuanqing, Lenovo's current CEO, will become president.

  In a press conference Wednesday, Yang said that Lenovo and IBM had been in talks for 13 months and that both parties believe the two businesses are complementary. Lenovo has a strong client base and sales infrastructure in the Chinese market, while IBM has a comprehensive network in PC sales on a global basis.

  Yang also said that during the first phase of the integration process, Lenovo's and IBM's PC operations will carry on as usual, independent of each other. After 18 months, Lenovo and IBM will use a common brand. He added that IBM's R&D center in Japan will continue to be important to the company.

  Separately, one senior IBM executive explained part of Big Blue's motivation for the transaction.

  "While we will have less revenue, we will have an improved financial profile," said Mark Loughridge, IBM's chief financial officer. It will also allow the company to sell more services in China.

  If it goes through, the deal will let IBM continue its shift from selling so-called commodity products to selling services, software and high-end computers. Although the company helped make PCs a global phenomenon, IBM makes little profit from PCs and often loses money.

  During the past several years, IBM has been edging itself out of the commodity hardware business by selling its PC factories in North Carolina to Sanmina-SCI and its hard drive unit to Hitachi. IBM is also likely eyeing new inroads into the Chinese market by working with Lenovo to gain an edge in selling servers and services in China, a fast-growing market targeted by a number of U.S. tech giants.

  Financial analysts say selling the PC business to a joint venture with Lenovo could add more than 5 cents per share to IBM's earnings in 2006, or $85 million in net income.

  "We believe a joint-venture structure in PCs makes sense between the companies, as the buyer would collaborate with IBM design teams for a period of a few years and the buyer would assume control of manufacturing," Steven Fortuna, an analyst with Prudential Equity Group, wrote in a report Tuesday.

  Meanwhile, it will give Lenovo the opportunity it has always craved to expand beyond China. In 2002, the company began to slightly expand into Spain and regional European markets but retreated due to market share losses at home.

  A major problem, however, is that the deal combines two radically different companies. Lenovo performs very little independent R&D and mostly manufacturers low-end systems. More than half of its sales go to consumers and very few systems get sold outside China, where it has strong ties to the government.

  IBM sells to the cream of the corporate crop and often to customers that have invested heavily in IBM services and software. Its flagship ThinkPad notebooks come with novel design features like fingerprint readers for additional data security and hard drives that can survive a six-foot drop.

  Challenges ahead
  "This is going to be a bigger challenge than both companies think. You are talking about a company (Lenovo) that has no experience internationally. They are very shrewd, but they are only used to dealing in the Chinese market," said Joe D'Elia, research director for client computing at iSuppli. "It is going to take quite a long time to consummate, and the only way I see this running properly is that if a lot of blood is shed at IBM PC."

  The deal also won't just require that IBM and Lenovo get along with each other. Sanmina-SCI owns the factories where IBM PCs for North America are produced and its contract to make those PCs is up for renewal next year. Because Lenovo does not have the factory capacity in place, the joint venture will have to negotiate a new relationship with Sanmina.

  In China, IBM manufactures ThinkPad notebook models in a joint venture with Lenovo arch-rival Great Wall Technology. Lenovo will gain the ThinkPad factory in Shenzhen, known as the International Information Products Co., but it said IBM server manufacturing located there was not included in the deal.

  Maintaining good relations with IBM's customers will be another concern for the PC group's new owner.

  One IBM customer said that as long as products such as the ThinkPad follow familiar paths, he will be satisfied.

  "We tend to base our decisions on quality control, features and functionality," said Shawn Nunley, director of technology development for NetScaler in San Jose, Calif. "So if it's the same product, where it's coming from probably won't make a huge difference. However, if they go the commoditization route...and it's no longer the ThinkPad way, then it might change my view."

  Nunley said he appreciates the work that IBM has done to integrate security features into its latest ThinkPads.

  For Steve Evans, vice president of information systems for the PGA Tour, sticking with IBM will depend on the details of the transaction and how much of the new company will be concentrated nearby. The PGA buys ThinkPads, servers and other IBM hardware.

  "We would need to figure out what the presence this company is going to have in the U.S.," Evans said, adding that it will also depend on the product lineup.

  One move that may reassure customers is that IBM Global Financing will become Lenovo's preferred provider for leasing and financing services, and IBM Global Services will be its preferred provider for warranty and maintenance services.

  Lenovo who? Lenovo, formerly known as Legend, is the largest PC maker in China. The company was founded in 1984 as a distributor of IT products. Over the years it started its own PC business, growing into the No. 1 spot in China. It also sells products ranging from cellular phones to supercomputers.

  During 2002, it ramped up plans to sell PCs globally. It even opened a Silicon Valley office and started selling laptops in Spain under its QDI brand. But it has been beaten back by competition from multinational PC makers, such as Dell, which have been growing rapidly in China. Dell, for instance, recently won a $10 million contract with Beijing's municipal government to supply Optiplex to primary and middle schools.

  Lenovo said it has responded to "irrational price competition among second-tier PC vendors and increased effort of foreign brands" with price cuts of its own.

  Despite the concerns of customers, industry analysts have said it could be a wise move for IBM to get out of building PCs. The timing could also be favorable. Although 2005 is expected to be a relatively good year for the PC industry, those good returns will give way to several years of slower sales of PC hardware, analysts have predicted.

  By the end of 2005, many businesses and consumers will have replaced their oldest computers, completing the latest PC replacement cycle, Gartner said in a report last week. Given that owners typically replace desktops every four years and notebooks every three years, there is likely to be a drop in demand between 2006 and 2008. That period will see average annual unit shipments slow to 5.7 percent and revenue growth drop to 2 percent, Gartner predicted.

  So-called emerging markets such as China are expected to see the best growth during that time, a boon for a potential IBM-Lenovo joint venture. But that could be offset by slack demand elsewhere, the Gartner report added, leading to further consolidation if PC makers don't prepare now by lowering their costs.

  Still, potential rivals are already throwing cold water on the deal.

  "We're not a big fan of the idea of taking companies and smashing them together. When was the last time you saw a successful acquisition or merger in the computer industry?" Michael Dell, chairman of Dell, said during a question-and-answer session at Oracle Open World. "It hasn't happened in a long, long time...I don't see this one as being all that different."

ZDNet China contributed to this report.