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Morningstar | Lenovo Posted Upbeat 1Q Results; Raising Our FVE to HKD 5.70. See Updated Analyst Note from 16 Aug 2018

No-moat Lenovo posted an upbeat fiscal first-quarter result (ended in June) that exceeded the market’s and our expectations, helped by the company’s efforts in transformation and cost control over the past several quarters. Revenue grew 19% year on year to $11.9 billion and pretax profit was $113 million, up $182 million from the year-ago quarter. While the personal computing and smart device, or PCSD, business continued to deliver industry-leading profitability and healthy cash flow, the losses from both the mobile and data center businesses saw remarkable improvements, with pretax margins up 3.4 and 9.7 percentage points year on year, respectively.

We are lifting our fair value estimate for Lenovo by 10% to HKD 5.70 per share from HKD 5.20, as we raise our five-year revenue growth forecasts to 3.7% (from 3% previously) and lower our average operating expense ratio to 12.7% (from 12.9% previously), in addition to the time value of money. We expect the company will continue to show consistent and accelerated results, but we think the mobile and data center businesses will remain loss-making for the next two years. We maintain our no-moat and negative trend ratings, as we are still yet to believe that the company will attain a sustainable economic moat through generating switching costs or sustainable cost advantages, given extremely short product life cycles and the nature of the highly competitive environments in which it operates. However, we think the shares are undervalued at current levels, trading at a 20% discount to our fair value estimate.

The PCSD business saw strong top-line growth, up 19% year on year to $8.3 billion, driven by robust demand in commercial and gaming PCs. Commercial PCs accounted for 63% of its PC unit mix, surpassing the industry average of 57%. In consumer PCs, the company continued to focus on premium segments, particularly thin and light (up around 40%) and gaming (up 20%) PCs, reporting strong double-digit sales growth. According to IDC, Lenovo maintained its status as the second-largest PC maker globally (22% market share), with shipments increasing 11% year on year to 13.8 million units, the fastest growth rate among the top five players. Meanwhile, the average selling price was up by 9%, thanks to the firm’s premiumization product mix strategy. On the profitability front, the segment pretax margin increased by 90 basis points year on year to 5%, which provided a solid base to fuel the growth needs of the mobile and data center businesses.

Sales from the mobile business dropped 6% year on year to $1.65 billion. The company saw some good results, as it has focused its resources on the Latin America and North America markets. Shipments in North America grew 92% year on year, driven by mainstream models including Moto G6 and E5, which were launched successfully along with carrier expansion. Encouragingly, the loss narrowed to $65 million from $129 million a year ago, with pretax margin improving 3.4 percentage points, thanks to the management’s efforts on reducing expenses and inventory from emerging markets.

The transformation execution in the data center business led to strong 68% year-on-year growth in revenue to $1.63 billion, a record high since the System x acquisition. The segment pretax loss further narrowed to $33 million from $114 million in the year-ago quarter. The pretax margin improved significantly by 9.7 percentage points to negative 2%.