Good morning, good afternoon. Welcome to Lenovo's Quarter 2 result webcast. This is Hugh Wu, VP of Finance at Lenovo. Before we start, let me introduce our management team with us today. We have our Chairman and CEO, Mr. Yang Yuanqing, our Corporate President and COO, Mr. Gianfranco Lanci, and our CFO, Mr. Wong Wai Ming . We will first start with our management presentation. After that, we will take your questions. Now, let me turn it over to Yuanqing.
Hello, everyone. Thank you for joining us today. This past quarter, we continued to transform our business by executing our three-wave strategy. Our revenue grew almost 5 percent year-on-year to reach nearly $12 billion.
Our pre-tax income was $35 million, improved more than $100 million quarter-on-quarter. Benefiting from tax credits, our net income stood at $153 million, flat year-on-year. For the first wave, our PC business, while we maintain the industry-leading profitability, our revenue outgrows the market, especially in Latin America, Asia Pacific, Europe, Middle East, and Africa. In China, under new leadership, the momentum has returned to growth. In fact, all geographies were profitable this past quarter. We also maintained growth in high-growth segments such as detachables, workstations, and Millennial PCs. Even in the shrinking tablet market, our volume has grown almost 9 percent year-on-year, and we have reached a record high market share.
This proves how our innovation and efficiency are effective in the scale business. In the future, we will continue to leverage market consolidation to retain leadership in profitability and market position.
The joint venture with Fujitsu we announced today will further grow our business in Japan, the third-largest PC market, and globally as we leverage its scale and efficiencies. Meanwhile, we will also invest in high-growth segments and the new emerging areas to drive future growth. For the second wave, we are building data center and mobile businesses into new growth engines. In the data center business, we have been building a solid foundation and our transformation is well on track. We not only maintain the leading position in high-performance computing and the traditional data center infrastructure, but also strengthen the technology and the products in software-defined, hyperscale, storage, and networking.
Our investment in the sales force since last year has taken effect in North America, Europe, Middle East, and Africa, where revenue year-on-year continued to grow for the second consecutive quarter, and profitability also improved. In China, after restructuring and strengthening our leadership team and product competitiveness, we saw quarterly improvement in revenue, a sign of turning around. We are confident that this business is on track to return to profitable growth.
We will continue to invest in this business to realize its high-growth potential. In mobile business, the turnaround is well in process as well. In most markets, last quarter, we saw strong premium-to-market growth year-on-year, especially Latin America and the mature market outgrew the market by around 66 points respectively. In emerging markets, despite the fierce competition by Chinese players, we continued healthy growth in Asia Pacific, especially in India.
In the high-end smartphone segment, we will continue to build competitiveness to enable breakthroughs and fully execute our strategy for profitable growth. In the future, we will continue to execute our clear strategy for our mobile business, strengthen our leading position and profitability in Latin America, aggressively drive breakthroughs in mature markets, including North America and Western Europe. In the short term, maintain healthy growth with controlled investment in emerging markets. In the third wave, we also made good progress as we continue to invest in device-plus-cloud . In technologies like artificial intelligence, smart office, smart home, and AR/VR to capture future growth.
Our first AR wearable product, the Lenovo Mirage AR headset, has been on the shelf for the coming holiday season. In the past several quarters, I know that our performance was not as good as expected, and it may have raised some concerns.
I want to share with you that Lenovo is a company that pursues deep thinking, hard work, and persistence. Once we decide on the direction, we would never give up. We will keep refining our approach and executing persistently until we find the right path to accomplish our goal. I want to share a story as an example. Brazil is known to be a very tough market with a double-digit interest rate, a complex tax system, and an extremely volatile exchange rate. Not many multinational companies can succeed in Brazil. As one of the top 10 economies in the world, it is a market that we were determined to win. Over many years, we tried approaches ranging from acquisition to sellout, from outsourcing to in-house manufacturing, from expatriate to local leadership, from unified to customized product portfolio.
We ran into many obstacles along the way, but we never gave up and kept refining our business model. In the last three years, performance started to gradually improve. Today, our PC market share reached almost 20 percent. We outgrew the market by more than 80 points last quarter and became profitable again after seven years of continuous losses. Our smartphone business outgrew the market by 26 points year-on-year.
Our market share reached almost 23 percent, strengthening our position as a rising number two player. Since the third quarter of last fiscal year, it has become not only profitable, but also the profit engine for our mobile business. In the future, we will continue our persistent execution to bring the same breakthroughs to India, Japan, US, Russia, and more markets. In the past two years, our data center and mobile businesses were also learning and refining execution.
Now, I'm confident to say that we are on the right path, and the performance will follow. The proposed purchase of Lenovo shares by our top management also demonstrates our commitment and confidence in the future of our company. Here, I will repeat what I said last quarter. Lenovo has entered a new phase of growth, and we should see sustained improvement in the following quarters or even years. Now, let me turn it to our CFO, Wai Ming. Wai Ming, please.
Thank you, Yuanqing. Now I will take you through Lenovo's financial and operational performance in Q2 fiscal year 2018. Next chart, please. Firstly, let me share with you financial highlights for the Q2 performance. For Q2 FY 2018, we delivered solid group revenue growth and continued our profit improvement quarter-to-quarter. Revenue was $11.8 billion, increasing 5 percent year -on-year and 17 percent quarter-to-quarter, as our PCSD business continued to drive premium revenue growth to the market. The transformation in our data center business remained on track and stabilized revenue quarter-to-quarter, and our mobile business also shows strong revenue growth momentum. Gross profit increased by 0.03% year-on-year and 18% quarter-to-quarter, while gross margin increased quarter-to-quarter to 13.7%. The improvement in data center business gross margin as a result of better product mix helped to offset the impact of component cost increase.
Operating expenses increased by 10% to $1.5 billion, largely due to the increase in advertising and promotion expenses for new smartphone launches in Q2 and the inclusion of the gain in property disposal of $206 million booked in the same period of the previous year that resulted in lower expenses. Pre-tax income was $35 million in Q2, an improvement of $104 million quarter-to-quarter. The improvement was mainly driven by profit improvement from our PCSD business, while the losses in both our DCG and MBG businesses continued to narrowed. In Q2, PCSD managed to improve profit margin quarter-to-quarter despite the component cost hike. The transformation actions in DCG started to take effect in Q2. We further improved our product mix with the launch of our most comprehensive product portfolio, resulting in a solid profit improvement, especially from mature markets.
Our mobile business continued its strong profit performance in Latin America, while China profitability stabilized. In Q2, we recorded a net tax credit of $118 million due to losses incurred in our mobility and data center businesses. As such, profit after tax for Q2 is $153 million, compared with loss after tax of $34 million reported in Q1. The board of directors in today's meeting declared an interim dividend of six Hong Kong cents, representing the same level of interim dividend paid last year. Next chart, please. Cash flow from operations improved quarter-to-quarter to $364 million in Q2, against an outflow of $577 million in Q1. The change was mainly driven by the improvement in operational performance, as well as better working capital position against the previous quarter.
However, compared to the stronger operating cash position a year ago, the change was partially due to the lower profitability year-on-year and increase in component inventory holding in this quarter, as we continue the buy ahead activities to mitigate the impact of component cost hike. Our net debt at the end of Q2 fiscal year 2018 was $1.4 billion, against $77 million in the previous year. The year-on-year change was mainly due to the fact that we paid down the $1.5 billion promissory notes to Google earlier this year that resulted in a lower cash level compared to a year ago. We continue to see improvement in our cash conversion cycle. In Q2, it was negative 14 days, an improvement of nine days year to year. Next chart, please.
For the PC and Smart Devices business group, global PC market showed further signs of stabilization during the quarter, despite the continued industry-wide component cost hike in Q2. The group PCSD team demonstrated a solid execution and achieved record high market share in EMEA and continued to gain share in Asia Pacific, and Latin America. PC business in China also regained its momentum with its recent channel enhancement actions.
We continue to see strong growth in fast-growing segments, including workstations, detachables, and millennial PCs. As a result, we recorded a premium-to-market revenue growth in almost all geographies. Revenue in Q2 thus increased by 7% year-on-year and 20% quarter-to-quarter to $8.4 billion. This was helped by an ASP increase that was up 6% year-on-year due to more innovative products and a better product mix. The business was profitable across all the geographies.
Pre-tax income was $367 million, up 26 percent quarter-to-quarter, faster than our revenue growth during the quarter, which is up 20% quarter-to-quarter. PTI margin improved by 0.2 percentage points quarter-to-quarter to 4.4 percent. Next chart, please. Our transformation in the Data Center business are well on track. For the first time since the acquisition of System x, we continue to see revenue increase year-on-year in North America and EMEA for the second consecutive quarters, which then contributed to the profitability improvement both year-on-year and quarter-to-quarter in our business outside of China. Our transformation actions in China, including strengthening our sales capability, also started taking effect in Q2 with quarter-to-quarter revenue improvement. Our product segment's performance, we continue to record double-digit growth in our global account business and remain the fastest-growing high-performance computer provider globally.
Margin in our hyperscale business has also improved due to better product mix and new customer wins. We now have the most comprehensive product portfolio in history, and we also secured 43 world -record benchmarks on our ThinkSystem, the most awarded x86 vendor in the industry.
Revenue from Data Center business continued to see quarter-on-quarter improvement for the second consecutive quarter to $976 million. Although we still recorded an operating loss of $100 million in the quarter, with our previous efforts in building the end-to-end organizational structure and the fast time-to-market product launches, our operational PTI margin further improved by 1.4 percentage points quarter-to-quarter. We continued our strong sales momentum markets outside of China in Q2. We recorded strong shipments growth and gained significant market share in Latin America, North America, and Western Europe, driven mainly by our mainstream product of Moto E and G.
Our new Moto Z2 has started to expand its footprint into more telecom carriers in mature market in Q2. We also achieved healthy growth in emerging markets, including India, where we increased market share in Q2. In China, we are focused on building multiple channels and prepare for new product launches, such as for Moto Z2. Revenue grew year-on-year for the third consecutive quarter to $2.1 billion. Operational PTI margin also improved 1.1 percentage point quarter-on-quarter, thanks to the margin improvement in Asia Pacific. However, we reported $132 million operational PTI loss, largely due to increased investments in marketing and promotion for new product launches during the quarter. Looking ahead, we can see our transformation is taking effect, and we believe our overall performance will continue to improve quarter-on-quarter.
Although the supply constraint and cost hikes in certain key components may continue to bring challenges to the group's short-term business performance, especially in our second half for MBG and DCG. We will continue to execute our strategy diligently to drive sustainable profitable growth over time. For PCSD, we have just announced the formation of joint venture with Fujitsu. We further strengthen our leading position as the industry consolidation trend continues, and will help to improve our position in the premium segment, as Japan is the third largest PC market with the highest average selling price. This joint venture will be mutually beneficial through synergies in scaling complementary product lines and R&D capabilities. We will aim to maintain our industry-leading profitability and drive growth in the fast-growing market segments.
We will continue to improve our user experience by leveraging our customer-centric segment structure, innovative products, and channel reform to drive future growth. For data center business, our transformation is on track. We will aim to continue to improve both revenue and profit quarter to quarter. We have turned more proactive in pursuing opportunities in the hyperscale business with our unique business model. We continue to demonstrate our rapid time to market capability of the new Purley product rollout, and are ahead of our competitors. Meanwhile, we will continue to strengthen our leadership in high-performance computing, software-defined infrastructure, and drive faster growth in the hyper-converged product segment. For mobile business, we will continue our investment to build the brand and expand our business in all geographies.
We will protect our leading position and profitability in Latin America, attack in the mature markets such as North America and Western Europe, and pursue healthy growth in key emerging markets. Looking forward, we see challenges such as cost increase and fierce competition from Chinese manufacturers in the emerging markets. However, we will continue to drive better margin performance and achieve profitable position over time. In conclusion, market competition remains fierce in the short term. However, the group now has a more customer-focused organization and more compelling product portfolio across all our businesses, enabling us to address more market opportunities. Coupled with our competitive cost structure and solid execution capability, we are confident that our quarter-to-quarter profit improvement will continue.
The recent share subscription proposal by Legend Holdings and the company's senior management team, subject to approval by independent shareholders, also demonstrate our confidence in the future prospect of the company. We remain confident in our vision and strategy to deliver long-term profitable growth. Thank you. Now we can take your questions.
Thank you, Wai Ming. Here, I am also pleased to introduce Kirk Skaugen, EVP and the President of Data Center Business Group. Kirk also joins the call. We want to accommodate
Gianfranco is on the line as well.
We want to accommodate questions from as many people as possible, so please avoid multi-part questions and limit to just two questions at one time. Please say your name and the name of your company before your question. All the Q&As will be English only. Operator, would you please give us the instruction?
Ladies and gentlemen, we will now begin the question and answer session. If you wish to ask questions, please press star one on your telephone and wait for your name to be announced. If you wish to cancel your request, please press the pound or hash key. Our first question is from the line of Arthur Hsieh from UBS. Please ask the question.
Hi. Good evening. Thanks for taking my question. My first question is with regard to the PCSD. In the September quarter, you delivered a phenomenal growth, and the market was actually not really that strong. I am wondering, aside from what is being mentioned, such as EMEA revenue growth and also regaining the China position, is there anything that you foresee the momentum could continue to carry into this current quarter? How would you characterize the current competitive dynamic in this PCSD business?
Is Gianfranco online?
Yuanqing, yes, I am online.
Yes. Would you please answer the question?
Okay. I think that you are right. The market is still slightly declining in PC But when you look at PC market, it's growing in revenue. But we have been able to outgrow the market by more than 5 points, right? And this is coming, I would say, from all the geo, EMEA, Asia Pacific, Latin America. We have seen a good comeback in China.
We are still fixing some few things in U.S., I would say, but mainly due to we decided in U.S. to step back from low-end education business that it's big in terms of PC, but not really good in terms of profitability. So growth is coming mainly from mid-end and high-end from premium, and this is the main reason of the revenue growth. So much better mix and much better AUR. Looking at this quarter, I think we see a similar trend.
On top, we are working in order to also come back in U.S. to a better growth and to a more solid growth in terms of mix and premium. We still see some component shortage issue, but we should be able to manage through the quarter, as well as some component that this is likely going up. We think that it will probably change starting from next calendar year. But I think we have seen a good momentum in all the geo. We continue to see a good momentum also this quarter in all the geo, I would say, including U.S.
Yeah. Adding to Gianfranco's answer. I think Lenovo is definitely strong in our PC business or this kind of volume business. Actually, we grow faster in the high-growth area, such as workstation, detachable Millennial PC, gaming PC. Even in the shrinking tablet market. The market dropped almost 10% year-on-year, but our volume also grow 9% year-on-year. So that proves our business model are really effective in this kind of scale business.
Thank you. My second question is with regard to the MBG. Well, I think the loss is understandable because of spending on the sales and marketing, but it seems the revenue growth is a little bit short of expectation. Is there any specific reason behind that? And does the management stick with the target to achieve breakeven toward the second half of the fiscal year? Thank you.
Actually, we have had a very clear strategy for our MBG business. Now, Latin America definitely has become our stronghold. That will be our first priority, to protect or to strengthen our leadership position in Latin America regarding of the market share as well as the profitability there. We should pursue the profitable growth in that geography. Our second priority will be attacking mature markets, definitely. We should be focusing on North America and Western Europe, because in those markets, actual competition is not that fierce. Also profit pool is larger than in emerging markets. In emerging markets, given we have a lot of competitors from China, definitely, the margin, the profitability, is not as good as in mature markets. Our emerging market strategy is we want to pursue the healthy growth with the controlled investment in those markets.
That in the short term, we will pay less attention to the volume growth to the market share in emerging markets. Definitely, improving the profitability or to turn around the business is still our first priority. We believe quarter-over-quarter, we will see the improvement. That's about our MBG business. Thank you.
Yeah, Arthur, I think that you probably look at the numbers, but if you, I think, take what Yuanqing said, I think our strategy, obviously, I think in rest of the world, I think if you really look at rest of the world, we are actually outgrow the market in terms of market share. I think we are growing, I think quarter-to-quarter by 20% and year-to-year by 6 something percent, while the market is actually about 4% or 5%. We actually outgrow. The reason you may actually just read the number, because we obviously have a strategy of contain our investment in China. If you take out China, in fact, we actually outgrow the market. Yeah.
Meanwhile, if you see the volume growth outside of China, it's pretty dramatic. Consistent with our strategy. Actually, we grow more than 60% year-on-year in Latin America. We grow more than 60% in North America and Western Europe as well. That's a pretty dramatic achievement. But definitely, it's mainly driven by mainstream and the entry-level product. We still needed to sharpen, to strengthen our premier price band product. Definitely, if we can have the stronger premier price band product, that will help us to further improve the profitability.
Right.
Thank you.
I can understand it is the China, probably it is not the focus. How about the target in terms of this turning around?
Yeah. I told you, turning around the business is still the first priority. We want to pursue the profitable growth in our MBG and the DCG as well. That is still our goal. We definitely, in third quarter, you will see the profitability improvement as well over Q2.
Thank you.
Thank you, Arthur.
Thank you.
Thank you, Arthur. Operator, could you help to call for the next question?
Once again, ladies and gentlemen, if you wish to ask questions, please press star one on your telephone and wait for your name to be announced. Once again, ladies and gentlemen, to ask questions, please press star one on your telephone and wait for your name to be announced. We have a follow-up question from Arthur Hsieh from UBS. Please ask your question.
Yeah. Well, I appreciate you to allow me to ask one more question. It is actually a question for Kirk, because I think, during the presentation, the management mentioned there was some improvement in the product mix for the hyperscale. Actually, Lenovo has really improved the position outside of China. Can you elaborate about, what was the change in the product mix? I thought at one point, hyperscale's profitability was a bit low, and that was not really the direction that we wanted to pursue. It sounds like you found a better approach, and it seems that the potential is actually not really that. In terms of this progress-wise, it is still one area that we want to invest. It would be good if you could help to elaborate on that.
Sure. I think our transformation is on track, and I want to be clear that hyperscale and public cloud is a core element of our growth strategy. As YY said, scale is critical to the Lenovo business model. Part of the transformation we are doing in hyperscale is the transition across the CPU generation from Broadwell to the new Intel Xeon Scalable processor. As YY said, we are leading that mix, we believe, relative to our competition. It was very difficult to change market share when someone had been buying the old product from a competitor of ours for several years. But now that the Purley or Intel Xeon Scalable is ramping, we are seeing good share gains across all our segments, including hyperscale. But the business model is also changing. In the previous generation, we basically just took an ODM product.
Now we are doing deep engineering collaboration with some of the largest public cloud providers in the world, and also putting those products into our own motherboard factories and our own system factories. None of those occurred in the previous generation. As we move to the new generation, we believe, overall for the DCG business, we should be at almost 50% share mix by the end of calendar quarter to the new processor. That is where we are seeing the share shift and the profitability improvement. Both the CPU transition and the business model change. Thank you.
Well, thank you. That is very encouraging. Thank you.
Thank you. Well, now we are going to take the last question for the interest of time. Operator, could you help to call for the last question?
Your last question comes from the line of Jim Liu from Goldman Sachs. Please ask your question.
Hello? Can you hear me?
Yes.
Okay. Thank you for taking my question. My first question is about the PC. Could you elaborate more about the component cost? How does that impact on the gross margin of the PC segment?
Gianfranco?
Yes, Jim. I think component cost, of course, is slightly impacting the margin because if you look our margin compared to last year, it is slightly down. I would say we have been able to transfer the cost increase to consumer SMB. It is a little bit more difficult to large enterprise customer where we have long-term contracts. You can make a very simple exercise. If you consider that the component cost has been going up around $30 during the last nine months, right? During more or less the last year almost.
We have not been able to transfer maybe $4 to $5 to get the impact. I think we have been able to manage the impact very well. So it is relatively slow. Moving forward, I think it is becoming even better because also on long-term contract with enterprise, we probably in the position to increase price.
Okay, got it. Very helpful. My last question is about data centers, or just follow up on Arthur's point. There are changes in strategy, so you will do more in-house capacity and provide engineering services with the data center locally. How would you be competitive against those competitors, especially Chinese players and also some Taiwanese ODM?
Sure. This is Kirk again. I think we are benefiting from the scale of having a phone, tablet, and PC business when we do our procurement relationship. We sell three to four devices per second, even though we sell about 100 servers per hour. We get the benefit, unlike some of our competitors, of having the scale on the PC, tablet, and phone side for procurement. Also, I think we have the ability to compete very aggressively, even against ODM. So we are not afraid of competing with the ODM for the business because we have global scale in 160 countries. As some of the China hyperscalers grow outside of China, they want a company that can grow with them outside of China. Lenovo is obviously a very global company with 160 countries where we have presence.
We are seeing benefit of growing with the hyperscalers outside China. With the deep engineering expertise, we also, when we acquired IBM, we got rack level integration capability. This is not about selling a pizza box, it is about the complex integration that we are bringing, not just to hyperscale, but also to supercomputing. Because we are able to cable up the entire machine and sell at a level 11 kind of integration level. This is something I think we have a unique differentiation on as well.
Yeah. Adding to Kirk's comment, we have strong in-house manufacturing capability as well. Definitely we can easily expand that into the server storage areas.
To put it in perspective, I think year-on-year, last year we did no custom motherboards. This year, we'll probably do over 50 custom motherboards for hyperscale.
Yes.
This is the level of customization and deep engineering collaboration we will do with the top hyperscale customer.
Yeah. Not only we can do the customized motherboard, but also, we can do that in a lower cost. That's what I always said. Lenovo is a company who understand how to balance the innovation and efficiency. We want to provide our customers the affordable or the competitive innovation and the product.
I just should reiterate, we believe hyperscale will be a profitable segment for us, and that is why we are pursuing it.
Okay.
I got it. Very helpful. Thank you.
Thank you, everybody, for your participation in today's call. If you have any further questions, please feel free to contact me or our IR representative directly. This webcast replay and conference call replay will be available in the next couple of hours. Thank you again for joining us today.
Thank you. Bye-bye.
Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect.