Lenovo Group Ltd

SELL: HKD 3.75(-27.04%)

Equity Research Department 20 October 2016 Analysts Tan Hong You Lenovo Crash: Rebooting The PC Lead Analyst, Equity Research Giant [email protected] We are initiating coverage of Lenovo with a Sell rating and a HKD Juliana Tian 3.97 12M price target. Analyst, Equity Research 2Q16 Earnings Review Soo Wei Jie Wesley  Total quarterly revenue down 6% y-o-y to US$10.1 billion Analyst, Equity Research due to slow growth or y-o-y industry declines in core Zhuo Yuxin business segments Analyst, Equity Research  PC shipments declined by 2.3%, a 1.8 point premium over market; tablet business saw double digit growth premium to Basic Information market Last Closed Price HKD 5.14  MBG pre-tax profit margins improved 2.9 points due to the 12M Target Price HKD 3.75 transition to higher priced products, despite a 6% y-o-y +/- Potential -27.04% quarterly sales decrease to US$1.7 billion, Bloomberg Ticker 992 HK Equity  DCG continues to face stiff challenges in mature markets, but GICS Sector Information Technology it strengthened its #1 market share position in China, GICS Sub-Industry Technology Hardware, increasing revenue 14% y-o-y, driven by growth in the Storage & Peripherals hyperscale business 1Y Price v Relative Index  Regional performance: China, EMEA, and Americas sales 10 dropped 9.8%, 7.3%, and 6.6% y-o-y respectively; Asia 8 Pacific sales increased by 6.3% y-o-y 6 4 Investment Thesis  Increasing urgency for Lenovo’s other growth engines to Lenovo Close HSI Rebased succeed given poor outlook and strong competition in

Company Description primary PC business, exacerbated by its reliance on China Lenovo is a leader in providing innovative consumer, market, which is experiencing slowdown in growth. commercial, and enterprise technology. It focuses on 3  Inability of smartphone turnaround due to poor smartphone main business groups, namely PC, Mobile, and specifications that do not meet the consumers’ demand Enterprise, primarily operating in 4 regions – Americas,  However, mobile growth engine unable to gain traction in China, Europe-Middle East-Africa, and Asia Pacific. smartphone market to replace declining sales in mature PC Key Financials market. Market Cap 57.098B HKD Basic Shares O/S 11.109B Catalysts Free Float  Lenovo’s FY16/17 Q2 revenue to underperform 15 analysts’ 52-Wk High-Low HKD4.49 – HKD8.82 consensus of US$10.99 billion due to continued lacklustre PC Fiscal Year End 31-Dec-15 performance, and a failure in smartphone turnaround despite Motorola rebranding efforts (US$ M) FY15A FY16A FY17E FY18E  Further strengthening of the greenback in December as a Revenue 46,295 44,912 46,416 48,416 result of a Fed rate hike, right before the financial year end, Gr Rate (%) 19.6 -2.99 3.35 4.10 will result in substantial currency translation losses for EBITDA 1,523 231 455 183 Lenovo Margin (%) 3.29 0.52 0.98 0.38 Net Income 970 -276 418 146 Valuations Margin (%) 2.10 -0.62 0.90 0.30 Our 12 month price target from date of coverage is HKD$4.66, ROA 0.03 -0.005 0.02 0.01 reflecting 66x our 2017E EPS of $0.06. ROE 0.20 -0.04 0.12 0.09

EV/EBITDA 9.05 12.32 5.41 4.94 P/E Ratio 18.79 14.37 10.21 8.97 Investment Risks  Strong adoption of AR smartphones will improve MBG’s Key Executives performance and Lenovo’s top line, improving its position as Yang Yuan Qing Chairman & CEO a future growth engine to drive Lenovo’s top line Gianfranco Lanci Chief Operating Officer  Successful merger and integration of Fujitsu’s PC business to Wong Wai Ming Chief Financial Officer improve PCSD’s performance and strengthen Lenovo’s PC market leadership, boosting valuations

Company Overview

Figure 1. Revenue by Business Group, FY15 Lenovo is a US$45 billion global Fortune 500 company and a leader in

providing innovative consumer, commercial, and enterprise technology. 2.00% 10.00% It focuses on 3 main business groups, namely PC, Mobile, and Enterprise, primarily operating in 4 regions – Americas, China, Europe-Middle East- Africa (EMEA), and Asia Pacific.

The company faces a challenging macro landscape due to significant currency volatility in key emerging markets, persistent declining of the 22.00% PC and tablet market, and slow growth in the smartphone market.

However, to counter the adverse macro environmental conditions, Lenovo has taken decisive actions to drive growth. Through its largest 66.00% restructuring efforts, Lenovo has more than US$1.3 billion in annualized savings to make it more competitive in the future.

In preparation for the age of “Internet of Things” and to achieve their vision of making life better and work more efficient by delivering smart PC Mobile Enterprise Others end-user devices, powerful infrastructure, all with connected services and apps, and the best user experience, Lenovo has made two key Source: Lenovo Annual Report 2015 acquisitions – Motorola Mobility and System X - to expand beyond their core PC business

2Q16 Earnings Review  Total quarterly revenue of US$10.1 billion; down 6% y-o-y Figure 2. Revenue by Geography, FY15 (down 4% excluding FX impacts)  Slow growth or y-o-y industry declines in core markets: decrease of 4.1% in PCs; drop of 11.1% in tablet shipments; flat server 16.00% industry shipments; smartphone market growth of 0.7% 28%  In the PC & Smart Device Business Group (PCSD), Lenovo continued to outperform the market: PC shipments declined by 2.3%, a 1.8 point premium over market; tablet business saw double digit growth premium to market  Despite a 6% y-o-y decrease of quarterly sales to US$1.7 billion, Mobile Business Group (MBG) pre-tax profit margins improved 2.9 points due to the transition to higher priced products

26.00%  The Data Center Business Group (DCG) continues to face stiff challenges in mature markets, but it strengthened its #1 market share position in China, increasing revenue 14% y-o-y, driven by 30.00% growth in the hyperscale business  Y-o-y decline in sales across China, EMEA, and Americas were 9.8%, 7.3%, and 6.6% respectively; sales in Asia Pacific increased by 6.3% y-o-y Asia Pacific EMEA Americas China  Moving forward: PCs will focus on high growth segments and Source: Lenovo Annual Report 2015 leverage industry consolidation to resume growth; smartphones will leverage innovative, differentiated products and continue to shift to higher price bands to drive growth and turn around this business; data centers will continue to expand in hyperconverged technology, and improve profitability in the Figure 3. Lenovo Phab 2 Pro – World’s First hyperscale business Tango-Enabled Smartphone Industry Outlook

Shrinking PC market In the short and medium term due to persistent sluggish demand According to the IDC Worldwide Quarterly PC Tracker, worldwide PC shipments in 3Q16 totalled nearly 68 million units, which is a 3.9% y-o-y decline. In the near term, the PC market is expected to further decline: growth in 2016 is now expected to be about 2% below earlier projections, as conditions have been weaker than expected, and in 2017 there will be progressively smaller declines. In the medium term, the PC market will continue to shrink, with IDC forecasting global PC shipments to decline from 256 million in 2016 to 249.2 million in 2020, which represents a - Source: Lenovo 0.7% CAGR.

This is due to the persistent sluggish demand for PC as consumers are not Figure 4. PC Shipments by Product Category buying new computers even if they need to buy one. Instead, they are and Regions (Shipments in Millions) buying tablets and smartphones as they are easier to use, more secure

160 and more portable. Moreover, the availability of free Windows 10 upgrades has delayed the necessity of purchasing new PCs. 137 140 131.3 124.7 PC market continues to be highly competitive 120 112.1 The stage of the PC industry life cycle can be described as mature, and the 100 85.9 industry is saturated with companies like Dell, Sony, HP, Apple and 81.4 Gateway. Over the past several years, price competition in the market for 80 73.1 64.7 63.9 66.6 PC have been particularly intense. 60 38.8 Increased levels of competition naturally led to price competition and 40 30.7 damp margins. Macroeconomics issues may lessen spending by 20 consumers and corporations and could be exacerbated if local and non- branded makers react by reducing already low prices. Companies risk 0 Desktop Notebook Total margin in favour of market share by trading considerably lower prices for shipment growth. Mature (2016) Mature (2020) Emerging (2016) Emerging (2020) Currency volatility to adversely affect industry bottom line Continued volatility in currency markets in 2016 will likely affect large Source: IDC technology companies with significant sales and costs overseas.

Companies pricing products in USD globally may be less impacted by

volatility. Yet, manufacturers weighted toward consumer products or Figure 5. Top 5 Vendors, Worldwide PC those with large cost exposure via R&D expenses may be more affected. Shipments, 2Q16 Companies with overseas sales and distribution channels may also be hurt, even with additional hedging that may have occurred amid volatility in 2015. Given Brexit’s impact on the euro, pound and yen, which are 27.70% 21.20% major operating revenue or expense currencies for hardware firms, currency impact may substantially widen over 2H.

Investment Thesis

1. Increasing urgency for other growth engines to succeed given 7.10% poor outlook and strong competition in primary PC business, exacerbated by slowdown in core China market 20.80%  Despite being the global PC industry leader with 21.2% market 7.20% share in 2Q16, the lacklustre medium term growth in the PC market will still adversely affect Lenovo’s top line, given that 16.00% PCSD contributed 66% to total revenue in FY15.  Moreover, in 3Q16, Lenovo’s lead over HP diminished to the Lenovo HP Dell ASUS Apple Others smallest margin since it took the top position in 2013.

Source: IDC  Moving forward, given China’s slowdown in growth and Lenovo’s heavy reliance on the market (China’s corporate PC market makes up 40-45% of Lenovo’s quarterly China PC Figure 6. Lenovo Global Smartphone Market volumes), it will be even more difficult for it to defend its market Share lead.  This makes it that much more important for Lenovo’s strategy of 6.00 growing future growth engines from MBG and DCG - through the 5.30 acquisition of Motorola Mobility and System X - to succeed. 5.00 4.10 2. Inability to gain traction in the smartphone market to help 4.00 replace declining sales in the mature PC market 3.50 3.50  Lenovo acquired Motorola Mobility in 2014 in an attempt to build future growth engines to move beyond Lenovo’s core PC

% 3.00 2.70 business, which is a mature business that is shrinking.

1.80  This gave Lenovo quicker access to the premium smartphone 2.00 market, and improved its competitive position in North and Latin American, given Motorola’s strong brand in these region. 1.00  However, it appears that Lenovo is unable to capitalize on this US$2.91 billion acquisition and convert it into a growth engine, 0.00 given that its global market share in the mobile phone market 2011 2012 2013 2014 2015 2016 has decreased steadily since the acquisition in 2014; according Year to Euromonitor, it dropped from 5.3% in 2014 to 3.5% in 2016.

Source: Euromonitor

 Incumbent smartphone market leaders are focusing on Figure 7. Server Vendor 2Q16 Market Share improving their smartphone design, screen displays, cameras and processor, which has a proven track record of appealing to consumers. The new Apple iPhone 7 boasts higher resolution cameras, faster A10 Fusion processor, richer P3 colour gamut 23.70% display screen. 34.60%  However, Lenovo and Motorola smartphones attempt to carve a niche for itself by focusing on AR technology and modular smartphones.  The next frontier for the smartphone industry is Augmented Reality (AR), and Lenovo is striving to gain first-mover advantage through the launch of AR enabled smartphone, PHAB2 Pro 19.10%  However, it is unlikely that AR will be widely adopted in the 6.30% short to medium term. Current mobile technology of short 7.10% battery life and slow broadband speed will deter AR adoption. 9.10% Significant investment in telecoms will be needed to create an AR friendly environment. Moreover, given the huge privacy concern HPE Dell IBM Lenovo Cisco Others brought about by AR, it can only go mainstream if consumers

Source: Gartner waive their privacy rights or the new tech guarantees a degree of discretion  Moreover, it does not appear that the modular smartphone Moto Figure 8. Operating Margin Z will appeal to consumers, given that consumers want simplicity by purchasing a brand new smartphone as opposed to 4.00% just a brand new mod. 3.50% 3.00%  The outlook for modular smartphone is also dim, given that the 2.50% devices are difficult to bring to market because their 2.00% interchangeable parts make them bulky and costly to produce. 1.50% Moreover, leading tech innovator Google has also axed its 1.00% modular smartphone programme - Project Ara. 0.50%  Moving forward, it does not appear that MBG will become 0.00% Lenovo’s growth engine any time soon, due to poor smartphone -0.50% specifications that do not meet the consumers’ demand. -1.00% -1.50%

Operating Margin/% Catalysts  Lenovo’s FY16/17 Q2 revenue to underperform 15 analysts’ Source: Annual Report, NUS Investment Society consensus of US$10.99 billion due to continued lacklustre PC Estimates performance, and a failure in smartphone turnaround despite Motorola rebranding efforts  Further strengthening of the greenback in December as a result of a Fed rate hike, right before the financial year end, will result in substantial currency translation losses for Lenovo, which reports its financials in USD

Figure 9. Cash Flow Management Financial Analysis

4500.00 4000.00 Overview: 3500.00 The financial condition chart above reveals Lenovo’s prospects moving 5 3000.00 years forward, highlighting our assumptions. While UA made a few 2500.00 acquisitions over the past 2 years, the impact on income statement is 2000.00 non-material and thus included in our projections. 1500.00 1000.00 500.00 Reduced Flexibility in Financing Future Ventures 0.00 Lenovo’s current D/E ratio is at its historic high, while expected to be paid down subsequently over the next few years, Lenovo has limited financing options in the short to medium term. We are expecting cost of revolver loan to increase should Lenovo continue to tap on more funding. Cash & Near Cash Items (M USD) Vulnerability in Periods of Adverse Cash Flow Shocks Having missed the annual earnings for the first time in 2015 since 2010, Lenovo’s share price traded down by about 190%. This reflects investor concerns over company’s revenue generation capabilities. In addition, a 5 years’ historic low in cash and cash equivalent highlights vulnerability in cash flow management. Lenovo is susceptible to revenue and cost induced shocks, with increasing risk of hitting undercapitalization.

Figure 10. Asset Turnover Ratio

3.00 Operating Margins Despite being an established brand, Lenovo’s operating margin has not 2.50 improved over the decade. In the last financial year, the company did not 2.00 breakeven. This raises concerns about the company’s long-term strategy 1.50 and the potential of their existing revenue drivers.

1.00 Asset Turnover 0.50 Lenovo has drastically increased its inventory holdings in expectations of 0.00 global expansion plans over the past decade, from USD5,450 million in 2007 to USD 24,933 million in 2016. However, the efficiency of the assets has dropped over the years, from 2.66x to 1.72x for their asset turnover ratio. Asset Turnover Ratio Interest Burden

Lenovo has consistently increase its proportion of debt as a mean for Figure 11. Debt to Equity Ratio financing over the decade, resulting in a high interest burden of 218.83%,

an amount significantly higher than its counterparts. 8.00 7.39 7.50 Tax Burden 7.00 6.51 6.45 The company pays a hefty tax bill of more than 40%. While being based 6.33 6.21 6.50 on China with an efficient tax rate of 25%, its global operations in 5.71 countries such as the United States has raised the overall tax burden rate. 6.00 5.34 5.50 4.82 4.73 5.00 4.61 Leverage 4.50 Lenovo has a considerably high leverage ratio in the computing industry 4.00 due to its pursuit of an aggressive strategy to capture market share. A combination of thinning cash flows and high cost of debt leads to higher risks for Lenovo.

Debt to Equity Ratio Valuations

Source: Annual Report, NUS Investment Society Valuation Price Target: HKD $3.75 Estimate

Figure 12. Extended DuPont Equation

Ratio 2016E 1 Tax Burden 46.29% 2 Interest Burden 281.83% 3 Operating Margin -0.22% 4 Total Asset Turnover 1.72x 5 Equity Multiplier 7.39x Source: Annual Report, NUS Investment Society Estimates

Valuation Summary

Equity Analysts' 28 Analysts' Estimates

Discounted Cash

WACC 5.1-7.6% Public

P/BV

P/E

EV/EBITDA

$0.00 $2.00 $4.00 $6.00 $8.00 $10.00 $12.00 $14.00 $16.00 0-25th Pctl 25-50th Pctl 50th-75th Pctl 75-100th Pctl

Figure 11. WACC Buildup DCF Model A discounted cash flow analysis was used to estimate intrinsic value of Cost of equity 8.32% Lenovo’s share price due to concerns with its cash flow generation Risk free rate 2.66% capabilities. The primary model is forecasted over 5 years due to relative Expected market risk 13.98% unpredictability of Lenovo’s growth trajectory. The model is driven by 4 Premium different segments as their revenue drivers, namely PC business group, Mobile Business Group, Enterprise Business Group and others, with PC Beta 0.50 business group contributing the majority of the revenue for Lenovo. COGS, Equity risk premium 11.32% SG&A and CapEx serve as crucial perimeters for projections due to After-tax Cost of debt 2.20% Lenovo’s nature as an aggressively expanding apparels retailer. Three cases were formulated, with the base case consisting of guidance from Cost of Debt 2.70% historical performance, annual report, industry outlook, along with Tax Rate 18.47% investor day presentations. The DCF is most sensitive to the following WACC 6.3% factors, derivation of which are explained below. Market cap ( USD '000 ) 6,685.75 Total debt (USD '000) 3,230.61 Weighted Average Cost of Capital (WACC) Debt-to-Total Cap 33% To calculate Beta, linear regression of Lenovo’s stock price were run Equity-to-Total Cap 67% against the S&P 500 for time frame of 12 months on a weekly basis and then averaged and adjusted. CAPM was used to estimate Cost of Equity, while a risk free rate and BBB- corporate bond was used during Source: Bloomberg, Damodaran, NUS Investment calculation of Cost of Debt in a weighted average manner. Tax shield was Society Estimates taken into account as Lenovo pays income taxes for all operations.

Revenue Growth Revenue growth for Lenovo is based primarily on increasing sales from mobile and enterprises through their recent acquisitions (Motorola in 2014) and expansionary plans (Lenovo-Motorla new mobile retail expansion in India). Lenovo has consistently maintained more than 10% revenue growth in the past 5 years, with the exception of FY2016 with a negative growth of 3%, While research and development helped to produce new, more attractive products for Lenovo, the growth from mobile and enterprises are unlikely to be as marginal as before. It is postulated that the PC market is saturated and Lenovo is unlikely to have an improved footing in the PC industry. Thus, we estimate a 5 year CAGR of 4.07% from 2017 to 2011 in our projections.

Terminal Growth As the industry becomes increasingly competitive and more markets hitting saturation point, Lenovo’s growth rate will definitely slow down. This rate will reach a terminal growth rate equal to expected inflation of 1.8%, accounted for in the 10 year DCF model.

Relative Valuation Using P/B, equity analysts’ estimates and EV/Rev, Lenovo is significantly overpriced relative to even high growth peers such as Asustek Computer Inc. Given the challenging competitive landscape and greater economic headwinds, we remain pessimistic about the outlooks of Lenovo being able able to keep up with growth expectations. This is further supported by using DCF, P/E and EV/EBITDA ratios for comparables. With valuations supporting both buy and sell argument, we decide to focus our valuation on our DCF, which provided a ‘sell’ rating HKD3.97 in the base scenario.

Relative Valuation was primarily focused on EV/EBITDA multiple. This is due to:

1) Compact spread from 1st to 3rd quartile of peer group P/E 2) Similar trends in historical multiple movements

This analysis leads to an intrinsic value of $4.66 for Lenovo, a 9% penalty to the current trading price. We remain confident that this valuation reaffirm our Sell recommendation and validates our view of upcoming 12 month period. Figure 12. Investment Risk Matrix Investment Risks

Market Risks M1: Weakening of dollar will lower currency translation losses for Lenovo

Business Risks B2: Strong adoption of AR smartphones will improve MBG’s performance and Lenovo’s top line, improving its position as a future growth engine to drive Lenovo’s top line

B3: Successful merger and integration of Fujitsu’s PC business to improve PCSD’s performance and strengthen Lenovo’s PC market leadership

Source: NUS Investment Society Estimates

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Appendix:

Scenario Assumptions:

Revenue

Expenses

Income Statement

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