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Morningstar | Lenovo Posts an Upbeat 2Q Result with Improving Profitability; Shares Fairly Valued to our HKD 6 FVE. See Updated Analyst Note from 09 Nov 2018

No-moat Lenovo’s September quarter results were ahead of our forecasts, with revenue and net profit up 14% and 21% year on year, respectively, stemming from strong sales growth in the PC and data center businesses, coupled with effective operating cost reduction. Helped by strong volume growth in the commercial PC segment, Lenovo regained its leading position in terms of worldwide PC shipments and pretax margin of PCSD remained healthy at 5%. Meanwhile, the losses from the mobile and data center businesses continued to narrow, leading to a significant profitability improvement in fiscal second quarter, with overall pretax margin up 1.3 percentage points from the year-ago quarter to 1.6%.

We are raising our fair value estimate for Lenovo to HKD 6 per share from HKD 5.70 to reflect the upbeat quarterly result and the time value of money, as we expect the company will continue to deliver consistent and accelerated earnings. That said, we think the shares are fairly valued at current levels.

We forecast the company’s revenue and operating income to grow at compound annual growth rates of 4% and 13%, respectively, through fiscal 2023. We assume sales from the PCSD and data center businesses will increase 4.8% and 9.6% per year, respectively, while mobile sales will decline at 4.4% annually. Our five-year operating margin averages at 1.3%, which is about 50 basis points higher than the past three years' average.

We maintain our no-moat and negative trend ratings, as we are yet to believe that Lenovo 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.

Revenue increased 14% from last year to USD 13.4 billion, the fifth consecutive quarter of year-on-year increase, which surpassed our prior forecast. By sales breakdown, the PCSD business was up 18% year on year, due to strong demand for the commercial PC and premium consumer PC segment, such as thin & light, visual, and gaming PCs. IDC data indicated that Lenovo was ranked number one in term of worldwide PC shipments (up 5.8% year on year), 6.7 percentage points higher than industry average. We forecast a high-single-digit increase in average selling price, driven by strong performance of gaming and commercial products. The business remained the only cash generator for the company, with pretax margin of 5%.

The mobile sales continued to decline in the quarter, down 15% year on year, owing to intensifying smartphone competition in the China market. However, the strong double-digit revenue growth in the North and Latin American markets was encouraging, driven by mainstream models, including Moto G6 and E5. On the positive side, the Motorola brand reached at breakeven point outside of China, as the company continued to execute its strategy to reduce expenses, simplify its portfolio and focus on North and Latin America. The mobile business reported a loss before tax of USD 81 million in fiscal second quarter, improving from USD 132 million a year ago.

Lenovo’s previous transformation investments in building sales capabilities, strengthening the channel and product solutions continued to drive strong momentum in its data center business. Thanks to a ramp-up in sales of higher-performance computing and hyper-scale products with leading technology and performance, the segment’s revenue grew 58% year on year in the quarter. The company moved one position up and became the worldwide number three server vendor according to IDC. The business reported loss before tax of USD 90 million in fiscal second quarter, improving from USD 100 million a year ago.