Lenovo (992.HK): Good Q4 but Currency a Drag

Q4 Highlights -Q4 revenues growth of 21%y/y were below expectations mainlydue to currency drags. GPM was 15.7% in the quarter, better by 2.4ppt than last year. The improvement was mainly fromcontribution of higher gross margin business ofIBM System X and Motorola mobile. Non-GAAP EPS was up 16.4%y/y. The firm finished the year with net debt position of US$199m. Lenovo also increased its final dividend from HK$0.18/share last year to HK$0.205/share.The interim dividend was HK$0.06/share.

PCSlip-PC revenues in the quarter declined 8%y/y due to impact from currency and slower demand ahead of a Windows 10 launch later in 2016. Lenovo’s PC shipments rose 2.7%y/y, compared to 7% decline for the industry. The company maintained its global market share leadership with 19% in the quarter based on IDC figures. PTI margins for PC improved from 5.4% in Q3 to 5.5% in Q4 and margins were up 1ppt y/y.

Challenges on Mobile -Mobile revenues rose 148%y/y, driven by the Motorola addition. Combined phone shipments in the quarter were about 18.7m. Management highlighted that the Chinese smartphone market continues to be challenging as telcom carrier subsidy cuts are changing consumer purchasebehaviours. There is some sentiment risk though if the market decides to focus on smartphone unit sales. Unit sales of Lenovo branded phones will see weakness over the next few quarters due to fierce competition in China and Lenovo’s declining sales of carrier subsidized phones. The offset would be the significantly better gross profit margins from sales of Motorola phones and increased mix of international smartphone sales. Additionally, success from the firm’s online distribution strategy could provide significant upside. The online strategy includes working with partners JD.comand Alibaba. Additionally, the company is looking to increase its smartphone penetration outside of China. Growth in Indonesia, Middle-East, Africa and India has been encouraging.CEO, Yang Yuanqing noted thatLenovo, thanks to the Motorola acquisition,faces less patent barriers overseas when compared to its Chinese competitors.

Enterprise Powering Up -Q4 sales were US$1.1bn, up US$941m mainly from the inclusion of the IBM x86 business. Reported segment losses were US$45m. COO, Gianfranco Lanci said group GPM margins likely sustainable going forward as mix of acquisition are accretive. The company is working aggressively in reducing the operating expense ratio and expects to realize margin improvement this year from the integration of the supply chain, R&D and optimization of the IBM-Lenovo product portfolio.

How Will 2016 Shakeout? -Management re-iterated its target to reach break-even over the next 2-4 quarters for its IBM and Motorola businesses. While we believe the time-frame remains reasonable, the declines in margins have to be a concern. Currency impacts and general seasonal Q4 weakness saw mobile margins slip from -2.6% in Q3 to -7.7% in Q4. Enterprise margins also lostground dropping from -3.4% in Q3 to -4.2% in Q4. For the first half of fiscal 2016, we expect Lenovo to report good top line growth as the comps will be favourable from the contribution of acquisitions. Revenue growth will become harder in 2H 2016 but Lenovo should begin to benefit from cost synergies associated with the integration of IBM and Motorola.

Forecasts and Valuation -Q4 revenues were significantly below our expectations but a better product mix, strong contribution from JVs and a lower tax rate resulted in earnings that beat our estimates. We are reducing our FY16 EPS estimate from US￠12.5 to US￠12.1 but maintain our FY17 estimate of US￠15. We raise our target valuation from US$13.10 to HK$16/share based on FY17 P/E multiple of 14X.

Recommendation -The stock has performed well thus far this year. Good results in the Q3 and support from Chinese investors via the SH-HK connect has resulted in share price appreciation of 33% YTD. Arguably, valuation remains reasonable as the stock is trading nearat its 3year historical average (see forward P/E chart) while China mobile peers ZTE and Coolpad are trading at a premium P/E. We rate Lenovo a BUY.