Lenovo's Margins Are Slim, But The Stock Looks Cheap

By Stephen D. Simpson, CFA | September 12, 2012 AAA

Investors who like to cast their lot with the darlings of the market will probably never like to own Lenovo (OTCBB:LNVGY). Although this Chinese PC, smartphone and IT hardware company has ample growth potential in both emerging and developed economies, the company's low margins and volatile results keep many people at bay. Although Lenovo is not going to be a good stock for those who worry a lot about volatility, there seems to be quite a lot of value in these shares.

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Continuing to Grow Through a Tough Market
These are not easy times in the global PC market, nor in individual markets like China or the United States, but Lenovo continues to substantially outgrow these markets.

Revenue rose 35% in the June quarter, while operating profit grew 46%. Although Lenovo did produce some operating margin expansion from last year's June quarter, the absolute level of margins (2.3% in the June quarter) is still exceptionally low compared to American peers like Hewlett-Packard (NYSE:HPQ), Dell (Nasdaq:DELL) and Apple (Nasdaq:AAPL).

SEE: A Primer On Investing In The Tech Industry

Building Strength on Strength
Lenovo was already the No. 1 PC company in China and the No. 2 supplier in the world, and the company is quickly closing the gap on HP. While the global PC market shrank about 1% in the June quarter (in terms of shipments), Lenovo's shipments grew 24%. While the company is very unlikely to match its 35% in China in the U.S., its strong position in the business PC category continues to grow.

And the company clearly isn't done yet. Lenovo has big share in China (about 35%), India (17%) and Russia (12%), but not much in Brazil (sub 4%). Now the company is doing something about that - buying CCE, the sixth largest PC vendor in Brazil, in a move that will make it the No. 3 overall player. There had been rumors that Lenovo would go for the much larger Positivo, but the CCE buy makes me think the company believes it can still garner a lot of long-term organic growth in Brazil.

Not Just About PCs
I believe that analysts and investors too often underestimate Lenovo's growth potential outside of its PC business. This flies in the face of Lenovo's declared "Protect and Attack" strategy - protect cash-rich markets like the Chinese and U.S. business PC markets, while aggressively expanding into markets like servers and smartphones.

On the smartphone front, so far so good. Lenovo has quickly built itself into the No. 2 smartphone company in China, with about 12% share. Samsung still heads the list at 20% share, but I wouldn't underestimate the company's ability to further take share from Nokia (NYSE:NOK) in the emerging markets and, perhaps, seriously enter the U.S. market at some point. To that end, it wouldn't be entirely out of character for Lenovo to consider buying Research In Motion (Nasdaq:RIMM), provided it still sees some value in that brand name.

Lenovo also recently announced a new joint venture (JV) with American storage giant EMC (NYSE:EMC). The two companies will get together to develop server products, while Lenovo will also distribute EMC products in China. This will be an interesting deal to watch. Neither company is strong in servers, but I wouldn't count out Lenovo just yet. At a minimum, this should be a good deal for EMC, as the company has a long history of ill-fated JVs in China, and the company's sales into the Chinese market are lower than they probably ought to be.

The Bottom Line
Although Lenovo generates very low operating margins and low free cash flow margins that needs to be set next to the fact that Lenovo still generates double-digit returns on capital, and seems to have found a defensible niche in profitably manufacturing mature IT hardware like PCs and notebooks. What's more, the company is still flush with cash, giving it multiple options in terms of acquisitions and product development investment.

SEE: 5 Must-Have Metrics For Value Investors

How undervalued does Lenovo appear to be? Projecting just 2% free cash flow compound growth over the next decade is sufficient to fuel a target price well into the $20s, even with an above-average discount rate. Although I don't think Lenovo is going to get much attention until investors feel better about the health of China's economy, I believe this is an undervalued way to play ongoing IT hardware demand growth in multiple emerging markets.

Stephen D. Simpson owns shares of EMC since September 2012.

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