Earnings Call: Q4 2017

May 25, 2017

Good afternoon, ladies and gentlemen. Welcome to Lenovo's 2017 annual results investor presentation. Welcome to all the guests here, and welcome to our participants in the webcast. Before we begin, let me introduce to you management with us today. They are Mr. Yang Yuanqing, chairman and CEO. Mr. Diego Franccoi, corporate president and COO. Mr. Wong Wai Ming, CFO. Last but least, Mr. Kirk Skaugen, executive vice president and president of the Data Center Group. Now may I invite Yuanqing to start the presentations, then followed by Wai Ming. Yuanqing, please. Thank you. Hello, everyone. Thank you for joining us. I will discuss our last quarter and the last fiscal year financial results, strategy, and the progresses in execution today. Last quarter, despite the challenging industry condition, Lenovo revenue resumed growth year-on-year after five quarters of decline, reaching $9.6 billion. Our net income was $107 million. In PC and tablets combined, while we faced the component shortage and the price increase, both our revenue and volume year-on-year grew for two consecutive quarters. Our average selling price improved, and we still delivered the 4.3% pre-tax income. In mobile, outside of China, we achieved more than 17% volume growth and outperformed the market by almost 13 points. Particularly in Brazil and India, our volume grew 56% and 34% year-on-year respectively. We also achieved breakthrough in Western Europe countries like U.K., France, and Germany. In China, we are reorganizing and rebuilding a stronger team. In data center, we saw profitability improvement quarter to quarter in every geo, except for China and Latin America. In China, we are proactively balancing growth and profitability of hyperscale business. For the fiscal year, our group revenue was more than $43 billion. We returned to profitability with net income of $535 million, more than $660 million higher year-on-year. In PC and the tablet combined, we were number one in worldwide share and outperformed the market by more than seven points, while maintaining industry-leading profitability of 5%. Last month, Laptop Magazine named Lenovo the best laptop brand for the year, unseating Apple, who had held the position for the past five years. In mobile, our transformation continued to deliver results. Outside of China, our performance saw quarter-to-quarter improvements every quarter. Last quarter, our revenue resumed growth year-on-year. Our premier smartphone, Moto Z, is on track to reach 3 million units sold within 12 months from its launch. Our average selling price improved more than 15% year-on-year. Last year, we united the teams, formed a consistent culture, and integrated the brand and the product portfolio. As such, we are on track to break even in second half of this fiscal year. In data center, we are still in the stage of investment and foundation building. With Kirk, our industry expert in leadership, we restructured our organization into end-to-end segments around the five market opportunities, and hired many experienced industry leaders. We continue to build core competence in software-defined data center and hyperscale businesses, as well as investing in partnerships and sales capability. Lenovo is recognized as the most reliable server provider by ITIC, and the fastest-growing supercomputing company. Beyond the operational results, last year, we focused on building foundational capabilities for long-term competitiveness. We have made solid progress in executing our three-wave strategy. Our PC business is the first wave. We continue to lead the industry in scale, profitability, and innovation. For the second wave, we are determined to invest further in mobile and Data Center Group to build them into our new growth engine. No hesitation, no reservation. Meanwhile, we look beyond this to capture new opportunities brought by cloud, big data, artificial intelligence, augmented reality, virtual reality, and natural language user interaction. We have quickly mapped out the third wave of our strategy, which is device plus cloud and infrastructure plus cloud. With this strategy, you will see that we are not only giving cloud and artificial intelligence wings to our existing devices, but also developing and launching new devices, new infrastructure, driven by artificial intelligence and the cloud. Lenovo's smart assistant and smart TV will invigorate your home. Our augmented reality technology will be applied to more vertical industries. Our software-defined infrastructure are the backbones for cloud-based infrastructure as a service, platform as a service, and software as a service. In summary, we have worked hard to finish the difficult part of the foundation building, and we will be well-positioned to harvest the fruit of our transformation. I am confident that we have the right strategy, right people, right organization structure to drive strong execution and achieve our long-term goals. Now, let me turn to our CFO, Wai Ming. Wai Ming, please. Thank you, Yuanqing. I will take you through the Lenovo financial and operational performance in our quarter 4 in the fiscal year 2017. Next chart, please. For fiscal year 2017, revenue was $43 billion, down 4% or 3% year-on-year, excluding currency impact. Gross profit declined 8% year-on-year, and margin decreased by 0.6 percentage point to 14.2%, impacted largely by component supply constraints with cost increases across the various products, as well as the transition of our Data Center Group business. Operating expenses were down 19% to $5.4 billion, helped by our previous resource action and disposal gain from the non-core assets. We, in fact, recorded the disposal gain of our real estate interest of $218 million in Q4. This offset the higher marketing expenses for smartphone launches during the year to support our new Moto brand products launches and expansion into more new countries. The group's reported profit before taxation was $490 million. Net other operating expenses totaled $182 million, which mainly consisted of the interest expense from our USD notes and RMB notes that we issued before, as well as the MTN issue in quarter 4, as well as the included interest in expense for the promissory notes. We recorded a net tax credit for the fiscal year, largely due to the tax benefit associated with the two acquired businesses. Profit attributable to equity holders was $535 million against $128 million loss recorded in the previous year. Turning to Q4. Our group revenue was $9.6 billion, up 5% year-on-year, helped by our strong revenue growth in mobile and PC businesses. Gross profit decreased by 10% year-on-year to $1.4 billion and gross margin declined by 2.3 percentage point to 14.3%. While we are still transforming our mobile and Data Center Group businesses, our margins were further impacted by the component cost hike across our various products, even though we took actions to mitigate the impact. As a result, our PTI was $15 million. We recorded a net tax credit during the quarter. Profit attributable to equity holders was $107 million. Basic earnings per share for the year was 4.86 U.S. cents, compared to a loss of 1.16 U.S. cents last year. The board decided in its meeting today to declare a final dividend of 20.5 Hong Kong cents per share. Next chart, please. The change in our balance sheet mainly reflect our business activities during the fiscal year. Non-current assets were $12.3 billion, and current assets were $14.9 billion. Major changes year-on-year were related to the issue of our MTN, as well as perpetual securities in Q4, and gains from the non-core assets disposal from the year. We have paid down half of the $1.5 billion of the promissory notes due to Google in Q4, and we have also repaid the rest of the promissory note earlier this month. Net current liabilities at $3.5 billion. Similarly, the year-on-year change was mainly due to the decline in business activities. The non-current liabilities was $4.8 billion. Next chart, please. Cash flow from operation at the end of fiscal year was $2.1 billion against $292 million in the previous year. The increase in bank deposit and cash, mainly due to the cash from the bond and perpetual securities issued in Q4. Netting off the partial repayment of the promissory note due to Google made in the quarter. Net debt at the end of fiscal year 2017 improved to $86 million from $1.2 billion in the previous years. We continue to see improvement in our cash conversion cycle. In Q4, it improved from zero days last year to negative 22 days this year. For the full year, it also improved from positive one day last year to negative 10 days this year. Next slide, please. The industry-wide increase in key component costs impacted various businesses last year, especially in the second half of the year, although we have taken actions to mitigate the impacts. We continue to grow our PC market share to a record high of 21.4%, further solidifying our number one position for the full year. Our PC shipments resumed growth in the second half of the year for two consecutive quarters in the PC plus tablet market. In the PC plus tablet market, sorry, Lenovo also remained number one with strong growth across high-growth segments. We grew 34% in gaming and 69% in detachable. Among the regions, we hit record high market share in China, America, and EMEA. Contraction of PC market and weaker currency conditions, though stabilized somewhat in Q4, continued to put pressure on our revenue. Full-year revenue was $30.1 billion, down 2% year-on-year and almost flat in constant currency. Revenue in Q4 was up 5% year-on-year, thanks to a better commercial refresh demand despite slower performance in North America due to component cost increases and inventory clearance. From a full-year perspective, net acting income $1.5 billion, margin up 0.3 percentage point year-on-year, thanks to the improved efficiency. For the mobile business growth. The group's strategic shift in our mobile business has started showing signs of strengthening, leading to a strong performance in markets outside of China. We recorded strong shipment growth in Latin America and signs of breaking through in Western Europe while keeping our solid position in emerging countries like India. Our innovative new products like Moto Z, Moto Mods, and the new generation of Moto G continue to receive encouraging customer response and increased activation rates. In China, we continued to execute our transformation strategy in rebuilding the brand and realigning our channel strategy. As a result, we recorded a decline in both revenue and shipments. Owing to the increase in branding and marketing expenses to support new product launches and increased key component costs, we recorded an operating loss of $566 million last year. For our data center business. DCG, under the new leadership of Kirk Skaugen, who joined the company in last November, is executing our transformation strategy and building the critical foundations for the business growth. We have already seen results in multiple geographies with enhanced focus and programs. We recorded double-digit growth in global account business and continued our solid performance in HPC. Indeed, Lenovo is currently ranked as the worldwide number two HPC company on the TOP500 list. We will continue to build a worldwide portfolio of solutions and provide end-to-end global sales and marketing teams with more sophisticated channel programs. We will also focus on increasing attach rates in networking, storage, and services to enhance our profits. Nevertheless, revenue is down 11% year-on-year to $4.1 billion and increases in the key component cost also impacted profitability, resulting in an operating loss of $343 million. Next slide, please. For China, total revenue from China was $11.8 billion, down 5% year-on-year, and profit down 4% year-on-year. Our overall margin in China remains stable at about 4.6% for the year. PC business continued to perform well during the year. PC market share improved to a record high market share at 37.1%, with stable margin for the year in Q4. However, as we are executing our transformation strategy in both mobile and our DCG business, which continue to have short-term impact on our profit performance in China and hence resulted in lower margin in Q4. We announced our new leaders in PCSD and DCG to drive business growth more efficient over time. For Asia Pacific, revenue down 2% year-on-year to $7 billion in the region. The decline was mainly driven by a soft PC and DCG business, although our smartphone business was solid with ASP and revenue growth. Increasing component cost has a negative impact on the region that resulted in a loss. For EMEA, revenue down 5% year-on-year to $11.2 billion, and we recorded an operating loss of $337 million. Similar to Asia Pacific, decline mainly driven from a soft PC and data center business. Our smartphone business has successful breakthrough in Western Europe, while we have made adjustment in our channel inventory, mainly to our product transition and soft market environment in the Middle East. Increases in key component costs also negatively impact to the region that resulted in loss. For the American regions, revenue down 4% year-on-year to $13 billion. Our PC business remains solid with stable margin, although facing significant challenges in the second half of the year from our competitors. Our profitability in Brazil continued to improve. Strong smartphone performance in Latin America, driven by Moto G and Moto Z, helped turn the region from loss into profit last year, offsetting the impact of the Data Center Group business. The region recorded a profit of $157 million, reversing the $121 million loss in previous year. Looking forward, we expect the industry-wide supply constraint and cost increases in key components will continue to bring challenges to the group's short-term business performance. The group will continue to execute its strategy diligently to drive sustainable, profitable growth over time. PCSD will continue to strengthen our performance of our PC business by leveraging industry consolidation while driving growth by launching more innovative products and focusing on fast-growing segments with vertical markets. For our mobile business, we will continue building the brand and expanding our scale across geographies. We will leverage our streamlined innovative product portfolio and broaden global carrier relationship and channels coverage. In China, we will continue to execute our business transformation plan. Through our previous resource action, our mobile business has now established a new competitive operating model and organizational structure to capture efficiency, which is set to help the profitability improvement of the business over time. For DCG, we continue to implement our transformation strategy and build a critical business structure to drive future business growth. This transformation strategy may require time to be effective, but we remain confident of returning DCG business to profitable growth over time. Despite the market conditions that will remain challenging in short term, we exited the year with stronger organization, allowing for sharper customer focus and more compelling product portfolio across all our businesses. In addition, we will continue to seek opportunities to strengthen our financial position as well as to look for inorganic growth opportunities. Together with our competitive cost structure and solid execution, we remain confident in our vision and strategy to drive the long-term profitable growth. Thank you very much. Now we can take your questions. Thank you, Wyman. Please be seated, and may I also invite Yang Yuanqing, Japan Code, and Kurt to come back to the stage. We will now move into the Q&A sessions. We will now take questions from the floor. If you wish to ask question, please raise your hand, and we will pass you a microphone. To make sure all of us, including our participant in the webcast, can hear your question, please wait for the microphone before you speak. As we would like to accommodate questions from as many participant as possible, please avoid multi-part questions and limit to only two question at one time. Kindly state your name and the name of your company before the questions. Now, may I take the first questions from the floor, please. English, Mandarin. Yes. The second row, gentleman. Thank you. In the last fiscal year, you did a lot in terms of monetizing your asset to enhance your shareholders' value. Do you think you still have room to do that in the new fiscal year? Are there other options that you may pursue apart from improving your core business? Thank you. Well, we clearly look at our balance sheet in a very careful manner. I think we will look at every opportunities to monetize our non-core assets disposal, so that we can actually generate the maximum cash to invest in our core business, to sustain the growth. I am not quite sure about your second part of your question. Are there any things that we improve our profitability? Core business. Yeah. I think one example is, for example, your sister company, Digital China. They actually try to release some of their business in other market. Is this something that you may consider? Thank you. Well, again, I think from a financial management perspective, first of all, I just mentioned that we will continue to look for opportunities to see any our non-core activity, non-core assets we monetize to generate the cash for investing in the core businesses. As well as in terms of looking for capital, we will continue to look for alternative as to what to execute in order to raise capital and then maximize value for the shareholders. We are looking at all possibilities. There is nothing in our plan that we cannot do. I think we will do anything that actually will enhance value of shareholders. Thank you for the questions. Next one, please. Hi. Thank you. How exactly do you intend to turn the mobile business into a profitable business, and timeframe, please? We still stick to our plan. We want to turn around this business in the second half of this fiscal year. With definitely the new product launch and the growing volume, particularly, outside of China. Thank you. The next question, please. Yes, the gentleman. Thank you for your presentation. In your footnote to the net income for the quarter, you note property gains and restructuring costs. Could you lay out for us what the largest items included in that are? Sorry, your question is, I think for the quarter or for the year? For the quarter, I think that we have a disposal of about 200, 210 million, I think for disposal our property interest. Then we have a restructuring charge of around 30 million. So net is about 170, 180 million. I think we actually took some resource action, I think when we restructure our China mobile business. Really make it more streamlined, more focused, and then also enable us to invest more in terms of marketing and branding, I think for the growth of the business in this fiscal year. Yes. Thank you. It's Joseph from Jefferies Securities. Three questions. First, since we are now in a new fiscal year, can you share with us your target for smartphone shipment for this year? So how much will be the growth compared to last year? Last year was a bit weak. Second is on the quarterly earning forecast perspective. We are very difficult to forecast our taxation. Last fiscal quarter was a way back in terms of tax. So can you give us some guidance on how we project your tax? The third question is about PC on the long-term perspective. How would you comment on the trend that when people are replacing their PC, they might probably switch to Mac or probably switch to a Microsoft Surface. So how would that impact on the OEM in terms of the future prospect for PC replacement? Okay, I answer first question, then Weimin second, Gianfranco third. I wish you have a question for Kirk for the Data Center Group, the next one. Regarding the smartphone target, last quarter we resumed year-on-year growth for the first time in probably five or six quarters. Actually, we grow 6% year-on-year on volume, close to 20% in revenue. That means our AUR, average selling price, was increased significantly. We are very satisfied with this progress. In the current fiscal year, we can keep this path. Next. Tax credit, well, I think probably everybody know how this tax credit works. It is really, I think, both the two businesses, they actually have quite a bit of accumulated losses that we carry forward. Any profit we make, we obviously, I think from a taxation perspective, need to offset those losses before we start paying tax, and hence you have the tax credit. I think going forward, we probably would still have some tax credit, but not really to that extent. I think it is not easy to estimate because obviously the taxation environment around the world is changing, and in particular, I think we have a new president in the U.S. proposing a lower tax rate. The tax credit benefit probably will come down. I would expect that there will be still some tax credit, but not to the quantum that we saw in this year or in particular, quarter four. Okay, it is my turn. On PC, first of all, let me make one consideration. Yeah, mic. When you look at PC market, just only PC, and you look at the last couple of quarters, we have seen the decline slowing down, right? It is down to a very small single digit. We expect that this is going to be more or less the picture for this year and probably also for the following year. So very stable. Even when you combine PC and tablets, so not really personal computer, but personal computing, or let us say PC device. IDC is going to change even their reporting numbers from PC to PC plus tablet, plus detachable, plus all the rest. You see also the market is relatively stable. It is not going to decline for the next two or three years. I think decline on PC is probably almost over. Another good thing when I look at replacement, frankly speaking, we do not see Apple growing. Apple is not growing share. We are not particularly worried, and people replacing PC, they need to switch to Mac because it is not happening. We do not see why it should happen. Even on detachable is a very interesting category, is growing. We grow last quarter almost 70%, so we have a good product line. We continue to introduce product. But we do not see, on the other side, if I look at the Surface result, during the last quarter, they have been declining. I think they have been declining simply because the category is growing. The number of price point is getting wider. They are covering only a very small, limited price point. I think rather than seeing really competition from Surface, I think we see that this category becoming bigger, and it is a good growth opportunity for us. We do not see really any issue from both today. Thank you. The gentleman in the middle, the third row, please. Hi. Wai Wai and Weimin. This is Arthur Lai from Citi. I have two questions. The first question is, I sense that probably the annual report delivery, you already do a lot of effort on it. But if you look at the next year, actually, we are facing a high component price environment. So how we improve or maintain our gross margin, even with this high component price? This is my first question. My second question is related to your not new, actually. The strategy on the device plus cloud and the infrastructure. Maybe can you share, or Kirk share more about this maybe cloud or data center strategy to us? I think this is also something long-term investor really focus on. Thank you. Yeah. Probably Gianfranco is appropriate to answer your first question regarding the component shortage impact on our GP margin. Component shortage, I think, we will continue to see, I would say, shortage or let's say price going up. It's really not a big shortage, but for sure pricing going up at least on SSD and some other things during the year. I would say mainly SSD and batteries. Memory, DRAM is becoming already quite stable. Of course, you have an impact at the beginning because you always need a couple of quarters to adjust the price. You cannot adjust price overnight. But I think we will continue to see a certain impact probably for one or two quarters, and then I think we should be back to normal simply because you can adjust price. On the other side, I think from one side, it's an issue. From another side, it's an opportunity because with our scale, I think we are not suffering in terms of shortage at all. We can deliver whatever we need to deliver in terms of product. While some small competitors, they may really suffer in terms of availability. Regarding our three-wave strategy, it actually includes two parts. The first is device plus cloud, the second one is infrastructure plus cloud. I will talk a little bit about the first part. Kirk, you can talk the infrastructure. What is the device plus cloud strategy? We think you know that Lenovo was a PC company, but PC at that time, is personal computer. We think in the future, PC will be the personal computing devices. It means it is not just the PC. It should include today's tablet and detachable, et cetera. It also includes the smart speaker. We just launched a smart TV and even VR, AR devices. That kind of smart devices. That is the broad PC range. Meanwhile, we will give the cloud and the AI, artificial intelligence wing to all these kind of devices. For example, PC today is not always on, always connected. We will leverage our Lenovo Connect, virtual operator, virtual SIM card business to drive the PC to the always on, always connected. Our PC users will be our monthly or daily active users. Also, we give the Lenovo Companion as a service to each of our PC users to help them to optimize their PC, to kill the virus, and to call our call center very, very easily. That is how we give the cloud wing to the devices. Over time, definitely, we can recommend other applications and the contents to our PC, tablet, smart speaker users. That is how we give the cloud wing to our devices users. Definitely. Over time, we can add the artificial intelligence to each of the devices so that personal computing will further evolve into the personalized devices. Personal cloud will further evolve into the personalized cloud. That is our strategy on the device plus cloud. We have made a lot of progress. Some product will be launched in this fiscal year. Some more are still in the development. Yes. Now on the infrastructure, I think, we see a world of obviously public cloud or hyperscale designs, but also a growing requirement for enterprises that were traditionally using traditional infrastructure that are moving to software-defined. I would say if you talk to the largest CIOs in the world, the biggest Global 500 accounts in the world, this is our fastest-growing market. We were up 16% year-on-year. The reason is people don't see us as Lenovo with legacy. We don't have a big legacy router business or a big legacy storage business. We're off promoting the transition to hyperconverged and composable infrastructure. We've been very fast-growing in the Global 500 accounts, our fastest-growing region. In hyperscale, we are not competing with our customers. Some of our largest competitors, especially here in China, have chosen to go into the cloud and compete directly with the customers. Our strategy is to build the infrastructure for our customers. We have a new Vice President of hyperscale that was one of the founders of WeWin, knows how to run this business very efficiently. And we're changing our business model. Unlike this past fiscal year, we're going to be building our own motherboards, putting those motherboards into our own factories, and engaging in deep engineering, not just with the China hyperscale accounts like Baidu, Alibaba, Tencent, but we're also predicting rapid expansion into some of the largest hyperscalers on the West Coast of the U.S. as well. As well as helping the Chinese hyperscalers as they grow globally into Europe and North America. I think we expect with this new business model, better profitability, in the current fiscal year than we saw last year. You want to talk the high-performance computing? Yeah. In high-performance computing, as you saw in the video, we're now the fastest-growing supercomputing company on the TOP500 list. These are helping the world do tsunami and hurricane prediction, global warming research, cures for cancer, this kind of thing. We intend to continue our growth in supercomputing and bridge that into artificial intelligence. Our new Chief Technology Officer is one of the world's foremost experts in artificial intelligence. Our job is to bridge being the world's fastest-growing supercomputing company and also number one in China, which is the fastest-growing supercomputing country, just passing the U.S., grow in all regions, but bridge that into artificial intelligence. Thank you, management, for the very detailed explanation. Due to time constraint, we have to end our Q&A here. I also need to announce that this is the end of our presentations. But if time allow, please stay behind and check out our new products. So once again, thank you very much for joining us today, and hope you have a good evening. Also thank you to our participant in the webcast. Thank you.