Lenovo Still Far From Getting Its Due

By Stephen D. Simpson, CFA | May 24, 2013 AAA

Every investor knows that China has seen a significant economic slowdown over the past year or so. Likewise, the ongoing struggles of the PC market (and, to a much lesser extent, the high-end smartphone market), have been amply reported in the financial press. As a manufacturer of predominantly PCs with a major portion of business coming from China, that would seem to spell bad things for Lenovo (OTC:LNVGY). While it's true that growth did slow noticeably in the fourth quarter, I continue to believe that Lenovo is significantly underestimated and undervalued by the market.

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A Modestly Solid Close To The Fiscal Year
Although times have been tough for PC makers, and not that much better for smartphone makers, Lenovo continued to gain share in these targeted markets.

Revenue for the fourth quarter was pretty mediocre. While Dell (Nasdaq:DELL) or Hewlett-Packard (NYSE:HPQ) management would be doing a happy-dance if they had Lenovo's 4% revenue growth, this was a bit below the Street average estimate and an uncommonly weak number for the company. On a more positive, sales in the MIDH category (basically everything not PCs, like phones, tablets, smart TVs and so on) were up 74% and now make up more than 9% of sales.

Lenovo's margins were also pretty solid. Gross margin improved by a point and a half, beating estimates by 70bp. Likewise, while operating income declined nearly one-third on a sequential basis, income increased two-thirds over last year and the company improved operating margin by 80bp (better than a 50% improvement) and beat estimates by 40bp. That said, the MIDH business is still loss-making, though the loss declined from $7 million in the third quarter to $4 million.

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Continuing To Build The PC Business
With HP struggling, Lenovo continues to build its share in the global PC business. After Lenovo nearly took the global share lead a year ago, HP's share rebounded but the companies are now separated by just 40bp, while Dell, Acer, and ASUS trail them.

Although Lenovo is still a share-gainer (and a profitable one), the PC story isn't entirely positive. For the first time in over two years, Lenovo's China PC business saw a year on year decline in revenue. While management doesn't believe this is due to much more than the tougher economic circumstances, the Chinese PC business is too important to Lenovo (more than 30% of overall sales) to be cavalier about this development.

Lenovo Still Has Work To Do In Mobile
Lenovo reported both good and bad news for its MIDH business. The company has grown its share of the Chinese smartphone market to 13% (#2 behind Samsung's 17% share), but the overall business is still not profitable. While there's nothing wrong with taking a long-term perspective towards the business, investors don't have limitless patience when it comes to profitless prosperity.

The good news is that Apple (Nasdaq:AAPL) doesn't seem to be making serious inroads yet, while companies like Nokia (NYSE:NOK) and BlackBerry (Nasdaq:BBRY) are virtual non-factors in the Chinese smartphone market (at least from the perspective of Lenovo). Lenovo enjoys a solid brand in China and if the company can successfully compete with new upcoming higher-end devices (with higher ASPs), the margin leverage could be considerable.

M&A Not An “If”, Just A “When” And A “Who”
Lenovo has never been shy about using M&A or partnerships to grow its addressable markets, and this company has an uncommonly excellent history of post-deal execution. Even so, that history of success hasn't made the company too cocky or careless with its deals – management still seems quite focused on the strategic rationale of its deals and disciplined with respect to price.

To that end, it's a widely-held belief that Lenovo and IBM (NYSE:IBM) have talked about IBM's x86 server business. Alas, price is the hang-up, as there have been various reports that Lenovo was unwilling to offer much more than $2.5 billion, while IBM wanted closer to $4.5 billion. I suspect that in time IBM will realize that Lenovo's offer is the best it will get and will relent on price.

At the same time, I wonder what other sorts of deals Lenovo might consider. Lexmark (NYSE:LXK) would appear to be attainable, and printing has attractive cash flow aspects (though not very good growth). Likewise, depending upon how Lenovo views its relationship with EMC (NYSE:EMC), bidding for a storage business could be an option. While I also thought that Nokia or BlackBerry could have made sense at one time, the movements in those shares since then has made a deal likely much too expensive for Lenovo.

The Bottom Line
Lenovo has unusually volatile free cash flow due to working capital entries like inventory. Consequently, looking at structural free cash flow (essentially operating cash flow before net working capital changes, minus capex) can offer a more predictable modeling trajectory. In either case, I believe Lenovo's focus on emerging markets will support revenue growth in the neighborhood of 7% over the next decade, with free cash flow growth in the low double-digits.

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That generates a fair value target above $30, and makes Lenovo stand out as a very undervalued stock on my list. While there are definite risks here (China's economy, competitors, low margins, and a faster demise of the global PC market), I think Lenovo's history argues for a greater benefit of the doubt today.

At the time of writing, Stephen D. Simpson owned shares of EMC.

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