Seeking Value in China: Lenovo

GuruFocus.com
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- By Mark Yu

Lenovo Group (HKSE:00992)(LNVGY), a $7 billion computer systems company, reported a 4.2% revenue decline to $43 billion and profits of $535 million (1.2% margin) compared to $128 million in losses in 2016.

As observed, Lenovo recorded gains in its "Other operating income/(expenses) - net"*** of $450 million compared to expenses of $715 million in 2016 thus leading to higher profitability in the fiscal year that just ended (1).


***According to filings, Lenovo's "Other operating income/(expenses) - net" consisted of all foreign exchange gains and losses that relate to monetary assets and liabilities denominated in foreign currency, gain or loss on disposal of property, plant and equipment is the difference between the net sales proceeds and the carrying amount of the relevant asset and government grants relating to costs.


"Despite challenging market conditions, Lenovo saw revenue resume growth in the fourth quarter after five quarters of decline.

"To drive further growth, we have clearly defined the three-wave strategy. We will maintain PC leadership in scale, profitability and innovation in the first wave while building our second wave, mobile and data center businesses into growth engines. Simultaneously, we will execute our third wave of 'Device + Cloud' and 'Infrastructure + Cloud' to capture the opportunities brought by new technologies. With this new strategy, we are confident of achieving long-term, sustainable growth." - Yang Yuanqing, Lenovo Chairman and CEO.



Total return

Lenovo ADR shares underperformed the broader Standard & Poor's 500 market so far this year with 4.3% total gains vs. the index's 8.8% (Morningstar). In addition, the company actually delivered 1.7% total losses compared to the index's 15.3% gains.

Valuations

Lenovo is overvalued compared to its peers. According to GuruFocus data, the company had a trailing price-earnings (P/E) ratio of 25.7 times vs. the industry median of 21.5%, a price-book (P/B) ratio of 2.2 times vs. 1.7 times and a price-sales (P/S) ratio of 0.62 times vs. 1.1 times.

The company also had trailing dividend yield of 5.46% with 47% payout ratio.

On average 2017 sales and earnings-per-share expectations Lenovo had forward multiples of 0.16 times and 250 times.

Lenovo

Lenovo is a Hong Kong-based investment holding company principally engaged in personal computer-related businesses. The company was founded on Nov. 1, 1984, as Legend.

Lenovo provides computers and other high-tech products and services. Its businesses include personal computer (PC) businesses, mobile businesses, enterprise businesses and ecosystem and cloud services businesses among others.

The company's PC products include laptops, tablets and desktop computers. Its mobile products are mainly smartphones. The enterprises businesses include acquisition, investment and other businesses related to cooperative projects. Ecosystem and cloud services businesses include consumer electronic products businesses.

In the recent year of operations, Lenovo generated 30.3% of its revenue in the Americas, 27.4% in China, 26% in Europe, Middle East and East Africa (EMEA) and 16% in Asia-Pacific.

Lenovo has four operating segments: China, Europe, EMEA and Asia-Pacific. In addition, it has four business groups: PC and Smart Device Business Group, Mobile Business Group, Data Center Group and Others.

China

Sales in China fell by 4.6% to $11.8 billion (27% of total unadjusted company sales), and the segment had an adjusted pretax income* margin of 4.6%, similar to 2016's profitability.

*The Lenovo Executive Committee assesses the performance of the operating segments based on a measure of adjusted pretax income/(loss). This measurement basis excludes the effects of nonrecurring expenditures such as restructuring costs from the operating segments. The measurement basis also excludes the effects of unrealized gains/(losses) on financial instruments.

Asia-Pacific

Sales in Asia-Pacific fell by 2% to $7 billion (16% of total unadjusted sales), and the segment delivered adjusted pretax losses of $65.2 million compared to $88.5 million gains.

EMEA

Sales in EMEA fell by 5.1% to $11.2 billion (26% of total unadjusted sales). The segment delivered an adjusted loss of $337 million compared to $125.7 million in adjusted profits in 2016.

Americas

Sales in Americas fell by 4% decline to $13 billion (30% total unadjusted sales), and the segment delivered adjusted pretax profits of $157.5 million compared to adjusted losses of $120.7 million in 2016.

Lenovo business groups

PC and Smart Device Business Group

In the recent fiscal year, PC and smart devices experienced a 2.3% revenue decline to $30 billion - 70% of total unadjusted company sales.

According to Lenovo, its global PC unit shipments decreased 1% year on year to 55.7 million against a market decline of 3%. Further, the company's market share continued to increase and achieved a record high level. Its worldwide PC market share was 21.4% for the fiscal year, an increase of 0.4% year on year.

Mobile Business Group

Sales in Lenovo's mobile business fell by 9.8% to $7.7 billion (18% of total unadjusted company sales).

According to filings, Lenovo's worldwide smartphone shipments for the year recorded a decline of 22% year on year, and its worldwide smartphone market share was 3.5%.

In review, Lenovo experienced an 85% decline in China shipments back in 2016. "In China, the group continued to record a decline in both revenue and shipments as it was under transformation that includes rebuilding the brand and realigning its channel strategy."

Data Center Group

Sales in Data Center Group fell by 10.6% to $4.1 billion (9.5% of total unadjusted company sales).

According to Lenovo this group was still undergoing its business transformation, delivering weak revenue performance. In addition, operational losses mount to $343 million excluding any adjustments. In 2016, this segment was known to be Lenovo's Enterprise Business Group.

Lenovo Capital and Incubator Group and Others

According to Lenovo, this group's identification began only at the start of the fiscal year with a mission to drive innovation through investment in startups and exploring new technologies.

During the recent year, the group continued to invest in several new smart devices and smart home/health care application developers and obtained great recognition from the venture capital industry.

Among all of the groups discussed, this "incubator and others" group segment is the only group that delivered growth - 16.5%. The group recorded revenue of $1.2 billion in the recent period.

Sales and profits

In the past three years, Lenovo recorded a 4% revenue growth and 0.9% profit margin average. Profits have grown/declined by 1.5%, (-)115%, and turned positive again to $535 million in fiscal 2017.

Cash, debt and book value

As of March, Lenovo had $2.75 billion in cash and cash equivalents and $3 billion in borrowings with debt-equity ratio of 0.94 times compared to 1.08 times in 2016. As observed, overall borrowings were reduced by $214 million while shareholder equity grew about the same figure.

Of Lenovo's $27.2 billion assets 30% were intangibles, while its book value grew by 35% to $4.1 billion compared to last year.

Cash flow

In Lenovo's fiscal year that ended in March, the company increased its 7.3 times to $2.1 billion. In addition to higher recorded profits in the recent year, Lenovo also recorded higher cash flow from its trade payables, notes payable, provisions, other payables and accruals.

Capital expenditures were $627.9 million leaving Lenovo with $1.5 billion - a five-year high. In review, the company had $991 million, (-)$437 million, (-)$611 million and (-)$459 million in free cash flows in the years 2013 to 2016.

Lenovo allocated 25% of this free cash flow in dividends. Nonetheless, the company issued $841.8 million worth of perpetual shares and another $6 million in noncontrolling interests in capital contributions.

In addition, the company made debt payments of $186 million, net any debt proceeds.

Conclusion

Lenovo demonstrated falling revenue growth in most of its business segments albeit with a little less severity compared to its performance one year ago. The company also registered (company defined) losses in both of its segments - Asia-Pacific and EMEA. These two segments generated 42% of Lenovo's total unadjusted revenue.

Meanwhile, the company's current cash in hand can actually pay almost all of its debt while appearing to have a leveraged balance sheet. Lenovo also had one-third of its assets in blue sky elements - goodwill and intangibles. Also, Lenovo also had some inconsistency in generating positive free cash flow in recent years.

An analyst that covers Lenovo had a price target of $11.9%, indicating a 4.9% decline from today's ADR share price of $12.52 a share (at the time of writing). Applying no sales growth multiplied by three-year P/S average followed by a 30% margin would indicate a value of $7 billion or $12.66 per ADR share - 1.1% from today's share price.

In summary, Lenovo is a pass.

Notes

(1)

(Company filings and red ink by author)

Disclosure: I do not have shares in the company mentioned.

This article first appeared on GuruFocus.


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