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. 1 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.