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Morningstar | Lenovo Posts Upbeat 3Q Results with Strong Margin Improvement, Raising FVE to HK 7.10. See Updated Analyst Note from 21 Feb 2019

Despite a challenging operating environment for PCs and smartphones, no-moat Lenovo’s strong December quarter results were ahead of the market’s and our expectations, with revenue and operating profit up 8.5% and 112% year on year, respectively, to USD 14 billion and USD 434 million. Profitability saw significant improvement across all businesses, with operating margin increasing 1.5 percentage points from last year to 3.1%, bolstered by robust shipments for premium PC products and effective cost controls. Net profit also improved substantially to USD 233 million from a USD 289 million loss in the year-ago quarter, when a one-time non-cash write-off of USD 400 million of deferred income tax assets negatively impacted the earnings.

We’re raising our fair value estimate for Lenovo to HKD 7.10 per share from HKD 6.00 to reflect the better-than-expected profit growth, as we increase our full-year fiscal 2019 revenue and operating profit forecasts to USD 50.1 billion (from USD 49.1 billion) and USD 1.05 billion (from USD 686 million), respectively. Our five-year revenue and operating profit growth forecasts are now changed to 4.7% and 17.4% (from 4.1% and 13.4% previously), respectively, while operating margin is expected to average at 1.7% (versus 1.3% previously). We think the shares are currently fairly valued relative to our new HKD 7.10 fair value estimate, and they have largely priced in the upbeat quarterly result, after the share price jumped almost 12% on Feb. 21.

While global PC market shipments had a single-digit declines (down 4.3% year on year) in the December quarter (according to Gartner) due to an industrywide supply shortage of processors, the company’s PC and smart devices, or PCSD, business had a stunning performance on both the sales growth and margin improvement. Lenovo not only retained its leading position, with market share in the global PC market at 24.6% (ahead of HP’s 23.6% and Dell’s 16.5%), it was the fastest growing PC vendor among the top five players. Segment sales were up 12% year on year to USD 10.7 billion, accounting for 77% of its total revenue, thanks to strong market share gains across premium and high-growth segments, as well as the commercial market. Sales from workstation, thin and light, visual, and gaming PCs rose 43%, 58%, 28%, and 15% year on year, respectively. Meanwhile, pretax margin increased 95 basis points from prior year to 5.4%, due to favorable mix shift and higher services attach rate. Management sees a huge room for growth in China’s PC market, which still lags the U.S. industry in sales volume and revenue.

While the mobile business recorded 20% year on year sales declines to USD 1.69 billion, accounting for 12% of its total sales, it turned profitable (a $3 million pretax profit from a loss of USD 124 million a year ago) for the first time since the Motorola acquisition in 2014, owing to effective expense reduction on the back of the strategy of focusing on core regions (Latin and North America) and product portfolio simplification. We think the performance was quite encouraging, given the turnaround timing happened earlier than we expected amid the slowdowns in the global smartphone market. While the business in Latin America remained profitable, Lenovo has gained substantial market share in Argentina and Mexico, and its smartphone market share remained the second largest (16.4%) in the region. Shipments in North America also saw significant growth of 30% year on year, driven by increasing consumer demand for the mainstream models and expanded relationship with carriers.

The data center business saw another quarter of solid growth and profitability improvement. Revenue was up 31% year on year to USD 1.6 billion, representing 11% of its total sales, boosted by stellar growth in the hyperconverged and software defined infrastructure segments. Meanwhile, the hyperscale business delivered triple-digit growth, thanks to its investments in improving its in-house design, manufacturing capabilities and customer mix. The business recorded a loss before taxation of $55 million, improvement from USD 86 million loss in the year-ago quarter, with margin improving from negative 7% to negative 3.4%.