Lenovo shares have lost 60% of their value from their mid 2015 peak due in part to the cyclical downturn in emerging markets and in particular China alongside a more structural trend of slowing demand for PCs globally. The stock screens as rather cheap with a 5% dividend yield and 12x trailing PE. These kind of metrics get my value instincts going so I decided to dig a little deeper.
In the annual report Lenovo blames the cyclical slowdown in China and general macro for the poor 2015/2016 results. They do acknowledge the slowing growth of the PC market calling it their core business but they are restructuring and looking to innovate going forward.
Qualitatively speaking this is not good news.
The way I see it building PCs is a commodity business. Back in the 1990s and 2000s the under penetration of computers was very high and so assembling systems was a profitable and growing business. However in 2011 we reached 'peak PC' and since that time sales globally have been declining. This is now an ex-growth business.
|Statista & Business Insider|
I think Lenovo continued to outperform the other PC majors (Acer, HP and Asus) since 2011 due to growing its market share and a predominant position in China. However since 2015 the stock has collapsed.
|Google Finance: 2011-Present|
So the principal questions are:
(i) Is this merely a cyclical downturn or is the PC market now a declining industry?
(ii) Is Lenovo capable of reinventing itself to grow in future?
In answer to (i) I struggle to see the PC market growing globally in future. The production of PCs is already heavily consolidated by the three big players; Dell (private), HP and Lenovo. There is limited scope for further consolidation. Demand is likely to remain relatively high due to business use of PCs with Windows and MS Office - I don't foresee a total collapse in the short term so this is not quite a 'Kodak' moment.
However Moore's law has now made PCs as powerful as they generally need to be. I think people and businesses will replace their PCs more slowly in future. This means lower demand. The last 5 or 6 generations of Intel processors have been becoming progressively more energy efficient and smaller but not really a lot faster - because they dont need to be. Therefore obsolesce is becoming less of an issue than it was in the 1990s - manufacturers need to build it into the product. Even Apple are struggling to really get consumers excited about each new iPhone or iPad development.
Beyond this PCs are a commodity business. Unlike Apple who own both the hardware and the software for the Mac platform - Windows will run on any of the PCs produced by Dell, HP and Lenovo.
I recently bought a Lenovo laptop. I only bought it because I got a good deal and it was cheaper than competitors. I wanted a laptop with Windows so I could use MS Office while being mobile. Now that means Lenovo produce a commodity. Commodities lack pricing power. I want Office and Windows therefore Microsoft have something of a moat here. But the hardware is of no interest beyond the basic specifications I get for the price. [Except I wanted a decent screen but realised at my price point they were all bad so I just went on price.] So without any real brand loyalty to the assembler the market becomes a race to the bottom pricing wise to gain the most market share.
The PC as a commodity is best highlighted by looking at Apple. Personally I prefer Windows and PCs for work and browsing however I have had three iPhones and I love the iPhone. Apple can price the iPhone well above an equivalent Android or Windows phone and I will still want the iPhone.
Why? Because I can migrate my old phone to the new one seamlessly. I like the design and feel. I am used to the operating system. This is the same reason really that I want a Windows PC with MS Office. But that Windows PC can be made by anybody. Remember those Microsoft adverts 'I'm a PC' - well think how that devalues the given PC manufacturer and captures value of Microsoft - the marketing is very clever - you want a PC but you don't think 'I want a Dell' or 'I want a Lenovo.'
So essentially Lenovo, HP, Dell etc add very little value. They simply assemble and package a set of components. Microsoft take a lot of the value for the software license with almost zero incremental cost for each unit Lenovo sells. Intel or possibly AMD will capture most of the value of the CPU. Seagate or WD or Samsung make the hard drive etc etc.
This is different to the great success of Apple. They made the Mac, Ipad, Iphone - the device to have - by packaging it and imbibing it with intangible value through design and ergonomics to be greater than the sum of its parts. It is all about marketing the product to create desirability and this allows Apple to charge more than the sum of the parts of the device and thus have a higher margin.
The underlying hardware in an Apple device is very similar to any other device but the key is they market their devices simplistically which appeals to humans view of quality and desirability. For instance the iPhone - they have generally kept it simple - one phone with a series of numbers '4, 4S, 5' which builds continuity and encourages an upgrade. The specifications are also simplified with an A8 chip or an A9 everything feels progressive. The first thing you see on the iPhone shop with Apple is the colour options for the phone! Yes recently they have added 'Plus' models but these are clearly larger - a plus size model - pardon the pun. Or the 'pro' designation on an iPad or Macbook.
Apple have recognised the key to making a product that is technically complex into something simple and desirable. You have to find external sources to see how much RAM or what clock speed the ipad operates at. In general PC manufacturers have a myriad of names and brands and numbering practices which instantly make comparing products even within the manufacturers own portfolio extremely taxing and confusing.
I don't see how any of the PC manufacturers have managed to make their products as desirable probably because Microsoft capture more of the value, a very clever move really because software is scaleable and capital light - let the manufactures assemble the PC and stick a copy of windows in it. I am certain Microsoft make more margin out of every PC Lenovo sells than Lenovo do.
Therefore this leads to my take on (ii) - can Lenovo reinvent itself to grow in future in a declining PC market? I doubt it. They have a very limited offering in mobile and are well behind the market shares of Apple, Samsung and Hauwei. In H1 PC and tablets made up 70% of sales. Mobile is 17% of sales and is declining too. Other revenues were around flat. It is therefore possible, but unlikely, that Lenovo can substantially change their offering and gain the intangible value that Apple has created for its products.
|Revenue including TTM has flat-lined|
Ultimately the feeling I got when I started looking at Lenovo was this company is a bit like Berkshire Hathaway - by which I mean the declining textile company that Warren Buffet really cut his teeth on, and lost, before it became the namesake of his mega conglomerate. This is a declining industry or at least one that is ex-growth. Lenovo run the risk of going the way of Blackberry and Nokia - i.e shrinking into obscurity in the long term.
|Earnings too are struggling to grow (2016 had restructuring costs)|
The question that remains is therefore; Is Lenovo a value trap? Or a value proposition?
I think Lenovo may be a value trap.
The 5% dividend yield looks good and with the predominant market share Lenovo may be able to run itself for cash over the medium to long term. Taking the HK$26.5 dividend for the year and assuming they pay say HK$27 next year, with a Ke of 8.68% and a 3% long run growth rate (ambitious given the declining industry but they could up the payout and run for cash) - I get a DDM valuation of HK$4.75. That is 12% less than the value of the shares today at HK$5.40. At a 4% growth rate we get HK$5.77 - so the present share price implies a 3.7% long term dividend growth rate. Ambitious for a company with declining revenues - but possible over the medium term given the current payout ratio is around 30-40% - assuming they can generate the cash flow.
However it is most likely that they will expend large amounts of cash trying to grow instead having recently acquired the carcass of Motorola Mobile from Google. I would like to see management focus principally on the PC market such that they do the one thing commodity companies can do; have the low cost advantage. Earnings may decline but the business could be well managed and cash generative. Trying to make up for lost ground in mobile seems fruitless at this point. As I say, I suspect in their desire to remain relevant Lenovo will waste a lot of money and not grow at all.
I note also the debt load has risen quite a bit recently presumably due to acquisitions - this increases the risk of the company going forward and makes the dividend less sustainable.
I think I will leave it there for Lenovo. I feel it is not cheap enough for me to get excited given the structurally poor long term prospects for the business. I could well be wrong but I tend to go with my intuition and back it up with solid analysis - I would review Lenovo again around HK$3 to 4 per share on the basis that my DDM valuation with a 0% dividend growth rate suggests a HK$3.11 value per share. That would be my baseline value for Lenovo assuming the underlying business is still viable.
Disclaimer: I have no interest in Lenovo shares at present. These are opinions only, not investment advice. If in doubt read my disclaimer.