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Despite share growth, margin improvement, free cash flow conversion improvement, and diversification into other profitable business lines, Lenovo (OTCPK:LNVGF) (OTCPK:LNVGY) has typically traded as a call on PC demand, and that would seem to be the case again now. While PC demand is indeed weak, and Lenovo management may be overestimating the pace of an eventual recovery (creating inventory management risks), Lenovo’s share price would seem to ignore the progress made elsewhere in the business.
I do think that Lenovo stock is undervalued on its merits (likely long-term free cash flows), but I also think that sentiment changes slowly and Lenovo could well remain a proxy for the PC market for a long time to come. I’ve done well for myself trading the shares, and I continue to believe that they’re undervalued, but it’s hard to recommend them beyond investors with a lot of patience to wait for the diversification efforts to bear even more fruit.
PCs Drive A Top-Line Miss, But Core Margins Outperform
Lenovo was hit hard by a weak PC market in the fiscal third quarter (December calendar quarter), but other businesses grew well and management once again exceeded sell-side targets for operating efficiency.
Revenue fell 24% as reported (or 18% in constant currency) from the prior year and 11% from the prior quarter, missing by 6%. The weakness was driven by the Intelligent Devices Group (or IDG), where revenue fell 34% yoy (and 16% qoq) on a 29% year-over-year decline in PC shipments. Infrastructure Solutions Group (or ISG) revenue rose 48% on 35% growth in server revenue, 52% growth in software revenue, and 345% growth in storage revenue, while Solutions & Service Group (or SSG) revenue rose 23% yoy on 12% growth in Support, 7% growth in Project & Solution, and 97% growth in Managed Services.
Gross margin improved 40bp yoy and 30bp qoq to 17.1%, beating by 50bp. Operating income declined 20% yoy and 12% qoq, beating by 10% on better expense control, while margin rose 30bp yoy and fell 10bp qoq to 4.9%.
By segment, IDG profits fell 37% (margin down 40bp to 7.3%), ISG profits rose 156% (margin up 60bp to 1.5%), and SSG profits rose 12% (margin down two points to 20.2%).
PCs Aren’t Out Of The Woods Yet
While most industry participants have been guiding for the PC market to bottom in the March quarter of 2023, there are still risks here to the outlook for Lenovo. While management claimed that sell-out ran 20% ahead of sell-in for the quarter (meaning that channel inventories declined), it looks like channel inventories are still at 10 weeks or more, which is historically high and a threat for further destocking.
Moreover, management has consistently been more optimistic than others with respect to the pace/depth of this downturn. Management has revised their guidance from flat to down 10%, but that just now puts them in line with the view of chip suppliers like AMD (AMD) and Intel (INTC), and the call for a double-digit rebound in the second half of calendar 2023 seems optimistic.
Given how quickly the value of finished PC inventories can erode, I’d like to see a little more conservatism here. Lenovo has maintained a leading share in the market ahead of HP (HPQ), Dell (DELL), Apple (AAPL), and so on, and gaming PCs continue to grow for the company, but excess inventory held too long in the channel could ultimately drive sharper clearance actions.
On a more positive note, despite significant weakness in the smartphone market, Lenovo has kept this business profitable for 11 straight quarters.
Diversification Starting To Pay Off, But More Work Is Needed
Lenovo has managed to turn its ISG business into a positive contributor to the bottom line, as well as gain share in the server and storage market. A big part of this has been a disciplined approach to the business that favors margin over volume and tie-ups with large customers that can drive relatively predictable business volumes (like Microsoft (MSFT) in storage). Management has also been doing well expanding the business, including a recent win with the Kroger (KR) chain to support its self-check-out efforts with Lenovo’s Edge AI servers.
The SSG has also been proving out as a worthwhile investment for the company. The core of this business remains in essentially elevated tech support, but it’s a worthwhile offering as it allows clients to operate with smaller IT staffs that spend less of their time on routine hardware support issues. Other offerings include project-oriented management services, where Lenovo essentially helps clients design and operate IT infrastructures, whether for specific tasks or enterprise/campus-wide needs.
That Lenovo got ISG into the black is certainly positive, but it’s still margin-dilutive. I think the company is on the right track as far as focusing more on value-added offerings, but I don’t see this ever really being a major profit driver.
On the other hand, the SSG operations have a longer potential runway of growth and growth at attractive margins, but I think it will take a while longer for the Street to warm up to this business. Infrastructure-as-a-Service makes sense, particularly as IT needs become more complex, and I expect more opportunities in areas like Smart Retail and Smart Manufacturing (basically designing end-to-end hardware and software packages to digitalize operations), but it will take time to build.
The Outlook
The PC business still generates more than half of Lenovo’s revenue, and it still drives sentiment for the stock. That’s not going to be a positive for at least a few more quarters. Likewise, the PC business will continue to be the driver of profits and cash flow for Lenovo for years to come, even with above-average growth in the SSG businesses.
I’m expecting this fiscal year to close with a double-digit revenue decline, with another modest decline following next year. Even with those headwinds, I expect long-term core revenue growth in the neighborhood of 3%, with ISG and SSG offsetting weaker PC/smartphone growth.
Lenovo has done an exceptional job of maintaining/improving profitability in its core PC business over the years, and I expect that will follow in infrastructure as well, though I don’t ever expect ISG to catch up to IDG in terms of profitability. The ongoing growth and profitability of SSG is a key driver, as I believe growth here over time can push the overall operating margin toward 5%, though I’m modeling a more modest long-term operating margin near 4%.
I expect long-term FCF margins in the neighborhood of 3%, though here too an expanded service offering could drive a higher long-term ceiling given less capex reinvestment needs. As is, though, I expect a little bit of FCF margin improvement to drive around 4% FCF growth off of that 3% revenue growth.
The Bottom Line
Discounted cash flow, as well as multiples-based approaches (EV/EBITDA, et al.), suggest meaningful undervaluation at this point. This is where the fact that Lenovo so often trades as a proxy for PC demand/sales comes into the picture – it doesn’t really matter what the valuation looks like if the Street only thinks of it as a PC play.
That could change over time, and I do think the shares are undervalued now, but I’ve learned over the years that there’s more money to be made expanding and lightening my holdings in response to the cycle of sentiment than waiting for the Street to change its views. With that, investors should approach the name understanding that value will take time to win out over sentiment.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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