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Lenovo begins its new fiscal year with a difficult quarter

23 Aug 16

Nearly two years after acquiring Motorola and IBM’s System x server business, Lenovo’s fiscal 1Q17/calendar 2Q16 earnings revealed lingering growing pains. Total revenue was $10.1 billion, down 6.2% year-to-year. Revenue from its two largest segments — PC and mobile — declined, while data centre revenue growth was essentially flat. Gross profit fell 6.8% year-to-year to $1.5 billion, and while operating profit climbed more than 150% year-to-year, the improvement was nearly entirely due to reduced operating expenses, not profit growth from increased product and service sales.

The company’s ambition to transform itself from a PC vendor into a purveyor of end-to-end solutions that encompass mobile and data centre products and services has taken root in its go-to-market strategy, where it is gaining share in tablets and fast-growing enterprise technology segments such as cloud, hyperconverged and analytics. The Motorola brand, System x install base and Lenovo’s efficient sales organisation combine to speed Lenovo’s entry into new regions and customer segments, especially in APAC.

However, the integration of Motorola and System x has yet to ignite overall revenue and profit growth, with smaller scale and lateness to market relative to its competitors in the enterprise and a stronger roster of smartphone competition in APAC, especially from Huawei, emerging as the largest obstacles for Lenovo to overcome. The revenue gains Lenovo realised through most of calendar 2015 were benefits derived from inorganic growth as Lenovo integrated its two acquisitions. Since calendar 4Q15, the first quarter to gauge year-to-year performance post-integrations, revenue and gross profit have declined an average of 11.3% and 10.1% year-to-year, respectively, each quarter.

Unit shipment declines in its PC segment are slowing, which in tandem with a greater mix of higher-ASP PCs helped limit overall revenue and profit declines in 2Q16, but data centre hardware commoditisation and a chaotic smartphone strategy have squelched most of the momentum Lenovo generated in 2015. Flat revenue in its data centre business, a 31% drop year-to-year in smartphone unit shipments as Lenovo effectively exits entry-level price bands and ongoing declines in the PC business illustrate the challenges ahead for Lenovo through 2017 to fully realise its post-PC vision.

Cutting costs is only a short-term solution to a more complex profit problem

Lenovo’s long-term strategy hinges on the ability of the Motorola and System x portfolios to counteract revenue and gross profit declines in the company’s PC segment. Lenovo’s ability to reinvigorate slumping businesses helped foster a short run of growth in its mobile and data centre segments in 2015, shielding the company from some of the impact of the weaker demand for new PCs as well as longer life cycles of existing devices. However, revenue gains realised over the last year have been more than offset by retreating mobile and data centre segment growth over the last two quarters, and operating expense bloat in these segments is perpetuating operating losses in its data centre and mobile segments.

Beginning with the layoffs of approximately 3,200 non-manufacturing employees, most of which were from the mobile segment, in August 2015 Lenovo has taken significant steps to bring the expense profile of its mobile and data centre businesses in line with lower revenue (mobile) or flat performance (data centre). The Motorola brand, which previously operated somewhat independently within Lenovo, was brought fully under Lenovo control earlier in 2016, and Lenovo announced a revamp of its mobile supply chain in July. In the data centre segment, smaller, dispersed IBM manufacturing facilities were absorbed into larger Lenovo facilities.

Lenovo’s global scale and brand strength ensure it will remain among the leading vendors in IT markets, and its manufacturing prowess will help protect its gross margins, which are typically among the highest in the PC and mobile device industries, even as year-to-year revenue and gross profit declines persist. In the PC segment, a focus on higher-ASP devices such as 2-in-1 notebooks and gaming PCs will help limit the negative impact of fewer units shipped on revenue and margin, while a shift from less-lucrative entry-level smartphones to midrange and premium mobile devices will provide a remedy for some of the profitability challenges in its mobile segment.

However, lower PC revenue results in fewer gross profit dollars - an important metric as PCs typically account for 60% or more of Lenovo’s total gross profit each quarter and help bankroll Lenovo’s smartphone and enterprise ambitions. Overall gross profit declines, which TBR believes will persist through 1H17 even as Lenovo endeavours to move its PC and smartphone customers up the ASP ladder and gain share in enterprise markets, will hinder Lenovo’s initiatives to reach the goals it has set for its mobile and data centre segments.

Article by Jack Narcotta, TBR senior analyst @JackN_TBR

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