Earnings Call: Q3 2017

Feb 16, 2017

Good morning. Good afternoon. Welcome to Lenovo's Q3 result webcast. This is Gary Ng, VP in investor relations at Lenovo. Before we start, let me introduce our management team with us today. We have our Chairman and CEO, Mr. Yang Yuanqing, Corporate President and COO, Mr. Gianfranco Lanci, and our CFO, Mr. Wong Wai Ming. We will first start with our management presentations. After that, we will take your questions. Now let me turn it over to Yuanqing. Hello everyone. Happy Chinese New Year. I wish the Year of the Rooster will bring prosperity to all of us. Last quarter, despite the macroeconomic uncertainty and the fact that we are still in the process of building our foundation and the core competence in the two new businesses, Lenovo delivered a solid performance. Our revenue reached $12.2 billion, and our reported pre-tax income was $101 million. Our PC and smart devices business continued its strong performance. Despite the decline in PC and tablet markets year-on-year, and the industry shortage of key component supplies, we achieved revenue growth year-on-year for the first time after seven quarters of decline. Pre-tax income was a solid 5% and an improvement year-on-year. Our PC volume grew 2% year-on-year, outgrowing the market by 3.5 points and reaching record share. We were especially strong in North America, Latin America, and EMEA. Outgrowing the market by 14 points, 16 points, and 8 points year-on-year respectively. We achieved hyper-growth year-on-year in the high growth segments, namely over 70% in gaming PCs, almost 100% in detachables, almost 260% in millennium PCs, and almost 80% in Chromebooks. Our tablet volume grew 10% year-on-year, outperforming the market by 29 points. PC and tablet combined, we remained number one in the world. PC is our stronghold. We can make products of any new category successful as long as we can leverage our established business model and the route to market in PC. We will continue to differentiate with innovation and leverage industry consolidation to gain share and keep a strong profitability. In mobile, we continue to see improved results as our turnaround strategy takes hold. Our worldwide volume continued to recover, growing at 7% quarter-to-quarter. We also grew almost 16% quarter-to-quarter outside China to surpass LG to become number four. Our mobile business outgrows the industry. In particular, we saw strong quarter-to-quarter growth in EMEA and Latin America. While our performance declined in Asia Pacific quarter-to-quarter due to supply shortage, in India we remained strong and grew our market share to almost 10%, despite the demonetization, which impacted consumption. We did all this while continuing to improve overall mobile business operating margin by half a point quarter-to-quarter. We also continue to see strong performance by Moto Z and Moto Mods products, and remain on track to reach our goal of selling 3 million units in the first 12 months. The mobile business is definitely getting better, but we still have much work to do. In China, we are still in transition, focusing on more competitive product portfolio and channel expansion. We are building broader carrier relationships globally, especially in key markets such as North America. We believe we will start seeing worldwide revenue growth year-on-year next quarter. We remain confident that our mobile business will deliver breakeven and start profitable growth in the second half of the next fiscal year. Our data center business is still in transition. When we acquired this business from IBM, we missed some capabilities, particularly the direct sales capability, and we had to depend too much on channel sales. This resulted in fluctuation in both revenue and profit. With a recognized industry leader now leading this business, we now have a plan to build direct sales capabilities. We have seen that where we have direct sales capabilities, we deliver good results, such as a 37% year-on-year revenue growth by our global account team. We are also fixing the hyperscale business model in order to deliver not only top-line growth, but also bottom-line improvement in China. Although the transformation will take time, we are already seeing signs of stabilization in North America, EMEA, and Latin America. We recently delivered our first ThinkAgile converged system to our client. In high-performance computing, Lenovo had the second-most system installations in the high-performance computing TOP500 list. Innovation continues to be a strength that drives growth across all our businesses. At the Consumer Electronics Show last month, we won 62 awards for innovative PCs, tablets, and mobile devices. Our smart assistant, powered by the cloud, which understands your voice commands and provides services accordingly, has attracted a lot of public attention. Our Legion brand gaming PCs also received rave reviews. We are also doing mini innovation road shows in 100 major cities all over China. I look forward to sharing more exciting announcements at the upcoming Mobile World Congress in Barcelona. Just last week, Lenovo announced a revolutionary manufacturing process that will dramatically reduce environmental waste and carbon emissions. Lenovo's industry-leading innovation will be a competitive advantage that continues to drive growth across all our businesses. In summary, market conditions may remain tough, with possibly higher component costs going forward. But we are confident in our vision, in our three-wave strategy, and in our execution capability. I know the transition will take some time, but I'm confident that we will achieve breakeven and then profitable growth in our mobile business and in our data center business. Now, let me turn it to our CFO, Wai Ming. Wai Ming, please. Thank you, Yuanqing. I will take you through Lenovo financial and operational performance in quarter three. Next chart, please. First, let us have a look at our Q3 highlights. Our group revenue for the quarter was $12.2 billion. It declined 6% year-on-year due to the continued challenging market environment, including the supply constraint in key components while our mobile business is recovering and we are still transforming our data center business. Revenue would have declined 4% year-on-year if excluding currency impact. Gross profit decreased by 15% year-on-year to around $1.6 billion, and our gross margin also declined by 1.5 percentage points to 13.1% due to the impact from the component cost hike across our various products and the impact from foreign currency fluctuations, even though we took actions to mitigate the impact. Expenses to revenue ratio was up 0.3 percentage points year-on-year to 12%, largely attributed to the increased branding and marketing expenses incurred in the launches of our new smartphone products and expansion into more markets. Our reported group PTI was $101 million. The reported PTI show a decline year-on-year as we are transitioning our mobile and data center businesses, as Yang Yuanqing mentioned, together with the increasing component cost. Net other non-operating expenses total $37 million, which mainly included the interest expenses from the USD notes and RMB notes we issued and the imputed interest expenses for the promissory notes. We recorded a net tax credit of $6 million for the quarter, which was mainly due to the tax credits associated with the two acquired businesses offsetting the tax charge in our PCSD business. Net income was $98 million, against $300 million from last year. Basic earnings per share for the quarter were 0.9 U.S. cents, compared to 2.71 U.S. cents last year. Next chart, please. The changes in our balance sheet mainly reflect our normal business activities during the quarter, as well as some long-term liabilities becoming payable within 12 months. Non-current assets were $12 billion, and current assets were $15 billion. Net current liabilities were $4.4 billion against $2.7 billion as of September 30th last year. The non-current liabilities were $4.3 billion against $6.1 billion as of September end last year. The Google promissory note will become due in October this year. As a result of which, it has moved into current liabilities. We have been planning the refinancing of this liability and do not anticipate any difficulty in executing those plans. Next chart, please. In Q3, we continue to see improvement in our cash conversion cycle, which improved from negative two days last year to negative 13 days this year, as we have successfully negotiated better credit terms with our major suppliers since late quarter two. In Q3, our cash flow from operation was around $345 million. Increase in bank deposit and cash quarter to quarter was mainly due to cash flow from operations and the remaining part of cash payment received in relation to the monetization of our real estates executed in Q2. We recorded net cash reserve of around $155 million at the end of the quarter, and will continue to drive improvement in our balance sheets. Next chart, please. PC and smart devices business growth. In Q3, PCSD business continued to deliver solid growth with strong margin. We maintained the worldwide number one position in traditional PC market with record high market share. In PC plus tablet market, we remain a strong number one and expanded our market share year-on-year. We have strong shipment growth across tablets and the high growth PC segments, including gaming, Chromebooks, and detachable products. Thus, our PCSD business recorded positive revenue growth year-on-year with a solid PTI margin of 5%, up 0.02 percentage points year-on-year. Mobile business growth. Despite facing challenges from component shortages, MBG turnaround plan is on track in Q3. The momentum was solid in rest of the world markets, with strong quarter-on-quarter shipment growth in Latin America and EMEA. Our MBG revenue increased 7% quarter on quarter, driven by ROW businesses. While we are still transforming our business in China. We could have achieved a higher shipment growth without the component supply constraint, and the increased component cost has also impacted our gross margin. As a result, we recorded an operational loss before non-cash M&A related accounting charges of $112 million for the quarter. We recorded a flattish loss quarter-on-quarter despite revenue growth, as we continue to invest in branding and marketing to support our new smartphone product launches and expansion into more market to drive future growth. Data center business growth. We are still in the process to transform our data center business. An industry veteran joined as our new leader and change action are in place to enhance our foundation and capabilities. While this action require time to be effective, we begin to see some early signs of stabilization, especially in our North America businesses. Nevertheless, in Q3, amidst keen competition and our focus on the balance between growth and profit in China, the group data center business group recorded a 20% revenue decline year-on-year, while the operational loss before non-cash M&A related accounting charges was $94 million in Q3, a slight improvement from a loss of $108 million in Q2. Next chart, please. For China, the revenue from China was $3.5 billion, down 2% year-on-year. The decline was reduced compared to previous period. It's due to our strong PC performance that reached record high share in this quarter, but offset by our smartphone and data center businesses. Our PTI margin grew 0.5 percentage points year-on-year to 5.2%, largely due to our continued operational improvement in PC. Asia-Pacific. Revenue was down 14% year-on-year to $1.7 billion in Asia-Pacific, mainly due to demonetization in India and component shortages, which impacted our PC and smartphone businesses for the quarter, while we are still revamping the business model for the data center group. Despite the challenges, the group maintained a solid number 2 position in the PC market and grew our market share in India smartphone market quarter-on-quarter. The decline in sales resulted in a lower operating margin. For EMEA. EMEA revenue was $3.4 billion, down 3% year-on-year, but improved 23% quarter-on-quarter as our PC business in the region resumed growth and reached record high share. We have started to expand our smartphone businesses in Western Europe. It recorded solid growth quarter-on-quarter, but recorded decline year-on-year due to different product launch cycles. We are still undergoing transformation in our DCG business, together with our investment in marketing and branding to drive our smartphone business, we recorded an operating loss in the quarter. Americas. Americas revenue was $3.6 billion, down 8% year-on-year, but improved 7% quarter-on-quarter. Our PC business in America remained robust. PC shipment increased by 12% year-on-year, outperforming the market by a 14-point premium, driven by the strong growth in North America. Our American smartphone shipments again show quarter-on-quarter growth while we are building broader carrier relationship in North America. Our Moto brand products continued to show solid growth during the quarter. The new Moto G product saw strong momentum in Latin America, while we also had successes with our Moto Z and Moto Mods product in North America. We continue our investment in the data center business to strengthen our sales capability, and we started seeing signs of stabilization in region, especially in North America. Our PTI margin for Americas improved by 0.5 percentage point quarter-on-quarter to 1.1%. Looking ahead, we will continue our focus on executing our actions to improve performance in each business. For PC, we remain confident that we will maintain leadership and drive growth with strong profitability in our core PC business by leveraging market consolidation, launching innovative products, and focusing on fast-growing segments and vertical markets. We continue our efforts to build mobile and data center business into new profit engines. We have a solid smartphone business in Latin America, and will continue to build a competitive operating model and organizational structure to capture efficiency in other geographies. For DCG, we are continuing our actions to enhance our capabilities and refine our business model, not only in the traditional technologies, but also for the new IT solutions. These transformation strategies may require time to be effective, but we remain confident to bring DCG business with solid business foundation to drive breakeven then profitable growth over time. Looking forward, market conditions may remain challenging due to the uncertainties in the macroeconomic environment, while constrained supplies of key components will likely increase cost and continue to bring challenges to the group business environment, especially as Q4 is typically low season for us. In spite of these market challenges, we will continue to execute our strategy diligently to drive sustainable profitable growth over time. In addition, we will continue to look for opportunity to monetize our non-core assets to enable us to further invest for the future growth of the group. Thank you. Now we can take your questions. Thank you, Wai Ming. We now proceed to questions. We want to accommodate questions from as many people as possible. Please avoid multi-part questions and limit to just two questions at one time. Please state your name and name of your company before your questions. All the Q&A will be in English only. Operator, will you please give us your instructions? Certainly. Ladies and gentlemen, if you wish to ask a question now, 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 comes from the line of Thompson Wu from Credit Suisse. Please ask your question. Hi, Yuanqing, Wai Ming, Gary. Happy New Year to you guys as well. Just a question on the higher component costs and supply constraints that you guys mentioned. I think this relates to probably DRAM. It seems like these constraints and price hikes might sustain through maybe the first half of this year. Just curious what Lenovo is seeing out there in terms of supply and pricing, and maybe a little bit more about how you're managing this across your businesses, both PC, smartphones, and tablets. Thank you. I would invite our CEO, Gianfranco Lanci, to give the answer. Okay. What we have seen, but this is mainly last quarter, for sure, some shortage on memories, DRAM, SSD, and also some other components, I would say mainly LCD, a little bit batteries and other things. Of course, the cost going up. But I think we have been able to manage during last quarter in terms of supply relatively okay, mainly leveraging our strength in terms of being number one. Moving forward, I think we will continue to see some shortage on memory, even though probably it is still this quarter, maybe next quarter, but it is getting better. Prices are likely going up still, but almost stabilizing, while we do not see any major issue on the other components, except maybe battery due to the accident of a few weeks ago. But overall, I think, yes, memory is still in shortage and will continue to be in shortage. Price, as said, are slightly going up, I think, but stabilizing. We are, I think, in a good shape in terms of supply. I think we should be able to get what we need on PC and also for the other businesses. But I would assume that the industry will continue to suffer for at least one or two quarters. Regarding the mobile business, definitely the supply situation is worse than our PC. We are facing component shortage, particularly in the camera image. These kind of things. Actually last quarter, if we could get enough supply, we could ship 2 million more to the market. Probably for the current quarter and probably the first half of the year, we are still facing the supply shortage challenge. But we wish we could operate better to try our best to deliver as many as possible. Thank you. Next question, please. Thank you. Our next question comes from the line of Gokul Hariharan from JP Morgan. Please ask your question. Yeah, hi. Thanks for taking my question. A couple of things to ask. One, on the PC environment. Looks like we are in an environment where PC declines are fairly moderate now compared to the beginning of last year when it was pretty bad. Any outlook in terms of how we see this continuing into the rest of the year? Are we expecting the PC declines to be fairly moderate or even pretty flattish in terms of the market going through the rest of the year? The second question I had is on mobile. For the breakeven target in mobile business group, going into second half of the next fiscal year, are we comfortable that at the current revenue scale itself, around $2 billion per quarter, we will be able to break even, or would we need revenue growth from these levels also to attain that break-even point? Thanks. That's okay. Yes. On PC, it is true that at least during the last couple of quarters, we have seen the declining, slowing down. If I look at this year, in my opinion, or in our opinion, it would still be a decline, probably in the low single-digit decline, but I don't think it's going to be flat year-on-year for different reasons. If you look, emerging markets are still on the negative side. If you take China is getting a little bit better, but Latin America is still in some cases even double-digit decline. Even some emerging market in EMEA are on the same side. We see good stabilization in U.S. and Europe, and partially Japan. But overall, I think it will be probably something in the range of -4% to -5%. What we need to understand that has been a little bit different during the last quarter is detachable growth. Because detachable, it was used to grow at very high growth, even 40%, 50%, 60% year-on-year. If you look last quarter, for the first time, detachable was negative growth. We are still growing very, very fast there, but I think mainly not because the market is growing, but because we are gaining market share against other people. So if detachable doesn't come back to growth, if we combine detachable and PC, I think we will still see negative growth also this year. Not as bad as last year or the year before, but we still believe that it's going to be negative. On the other side, we will continue to see consolidation moving forward. I think we top three, we continue to gain share, while the other people, I think they will continue to struggle. There are still good opportunities in terms of growth from our side, but not because the market is growing, simply because other people are slowing down. Okay. Thank you, Gianfranco. Regarding the MBG or Mobile Business break even or turnaround plan, we are very confident. We can deliver that. Definitely, this is a plan, not just to drive the turning around, but also to drive the growth over time. Definitely, we are not satisfied with just $2 billion per quarter revenue. Actually, as I just said, even last quarter, if we have enough supply, we could ship 2 million more to the market, probably with that 2 million, we could break even in this business. Actually, today, our operational expense is around $400 million per quarter. I think, not only we can grow our top line, but also we can improve our gross profit. Last quarter, actually, we were hit not just by supply shortage, not just in the shipment, but also in the cost, in the material cost. I think if we could improve the gross margin to around 20%, we definitely can be easy to make money. I do not think that that is mission impossible. That is why I am confident. Actually, that is the story for the rest of the world. In China, probably it is a little bit different. For the next fiscal year, I do not think our China business will lose more than $100 million. We definitely will mitigate the risk in China market. Thank you, Jin. Thank you, Gina Qiao. Next question, please. Thank you. Next question comes from the line of Jenny Lai from HSBC. Please ask your question. Yes. Thanks for taking my question. I actually have two questions here. We have been seeing news reporting talking about Lenovo might be going to single brand strategy, meaning, in the future, there may be only one brand, that is Moto. Could you comment on your future branding strategy here? That is my first question. The second question is regarding the PC consolidation comments. The thing is, we have been seeing PC consolidation for quite a while, and now it seems like the leading players, there are not many surviving players. Let us say five years from now, what do you think the market is going to become? Is it going to be a three-player market? Is it something that you are envisioning for the future? Those two are my questions. Thank you. Yeah. Regarding the mobile branding strategy, we will make it clear, make it simple. Actually, in the rest of the world, we have already formed the strategy. We will use the Lenovo brand to be the major brand to address the market. But for China, we are still discussing that. We haven't made the final decision on our China branding strategy. But I think the simpler branding strategy will benefit the business. Okay. Regarding the PC consolidation. My favorite subject. Okay. I would not say that it is going to be a picture with only three players. It is probably going to be a picture with maybe four to five players. Because we should not forget that there are also some other players not running Windows. But having said that, if you think about the picture with four to five players, there is still a lot of room in terms of consolidation. There are still some local players here and there in different parts of the world. There are still some other players that they continue to lose share during the last couple of years. But I would say in a couple of years from now, in my opinion, we will see only four to five players left. And this is why we still believe that shooting for 30% market share is challengeable. It is very challenging, but it is not a dream. Yes. Thank you, Gianfranco. Thank you. Our next questions, please. Thank you. Our next question comes from the line of Arthur Lai from Citigroup. Please ask your question. Hi, YY and Weimin. Thanks for taking my question. This is Arthur. We understand that the trend is everything going to the cloud, and how we make the money from the DCG and in the future is data center service business. Can you share with us your strategy on the turnaround of the DCG and also the new business in the data center? Okay. Thank you, Arthur. Definitely, DCG business is a new business for Lenovo. To some extent, we are still in the learning stage. Fortunately, recently, we hired a very experienced leader to lead this business. Definitely here, I can give you some very simple and preliminary thoughts on this business. Actually, this DCG, data center enterprise business, is shifting from mature markets to emerging markets. Actually today, the growth is not in the U.S. The growth is in China. Actually, the U.S. and China probably account for more than 50% or 60% of the total market. China is growing faster than the U.S. and other mature markets. The second is this market is shifting from the traditional enterprise customers to internet companies, the so-called IPDC market. Data center market. The third one, the third shift, third trend is from a technology point of view, it is shifting from the traditional IT to the new IT. The traditional IT is separate servers, storages, and the network. The new IT will be hyper-converged technology. Computing, storage, and networking will be combined together. Everything is software-defined. That is three clear new trends. Definitely Lenovo is trying our best to address all these three trends. Unfortunately, we have to address these trends simultaneously with the integration of the acquired business. Fortunately, we do not have any legacy. Compared to other competitors, we are in a better position, particularly addressing the third trend. I just talked from the traditional IT to new IT. Also, I think we definitely have that advantage in China market than our traditional competitors, like HP and Dell. Definitely, we also understand that we have a lot of things to do. Particularly in China, it is shifting to the hyperscale market, to the IBTC or internet companies, very fast, faster than the rest of the world. So far, we have not built a solid business model for this trend, or for this shift, for this new category of the customers. We need to refine our business model to ensure not only we can grow in that market, but also we can make more money, we can be profitable in that market. As long as we can grow that market in China and make money in that market, I think it will be easy for us to grow and to be profitable in rest of the world, particularly in U.S. IBTC market. That is what we should address. Definitely. For the hyper-converged, actually we are leading in that space. We have built a very good relationship, a partnership with the company like Nutanix, et cetera. Definitely to fix our data center business. Addressing this shift is not enough. As I said, simultaneously, we must fix the integration issue. Actually, when we acquired the business from IBM, we missed some capability, particularly the direct sales capability. Because of that miss, we have to rely on more our PC sales force. We have to rely on more indirect sales model. Although we are doing well in that space, but it is not enough because in the industry, 80% of the enterprise business is through the direct. Only 20% are through the indirect. In Lenovo, we are in reverse situation. We must fix this issue simultaneously. Fortunately, we have seen the first signal, particularly in the North America and the EMEA market. Actually, after we started to increase the direct sales force, last quarter, for the first time, we see the quarter-to-quarter revenue growth. That is a definitely a positive signal. That is what I want to address on our data center business. Thank you, Wai Wai. Thank you, Arthur. Due to time constraints, let us take the last question. Thank you. Our final question comes from the line of Joseph Ho from GF Securities. Please ask your question. Hi. Thank you for taking my questions. Two questions. The first one is about the losses in the EMEA area. We see the losses, one of the reasons is that you are spending more on the marketing and branding, which is a discretionary decision of your choice. So how would that pan out in the next quarter, next two quarters? Are you going to control the losses there by scaling back on your expenses? Or you will continue to invest in order to get more sell-through in the EMEA? You want to go? EMEA. Loss. So spend more money on the marketing. Well, I think it's That was my fault. EMEA. I think it's a combination of because when you look at the EMEA result, it's the combination of the three businesses together. So it's DCG plus MBG plus PCSD. For sure, there are some cost or some additional expenses coming from marketing, and I think we are going to control better for this quarter. On the other side, as we said, we also needed to turn around DCG in terms of loss in order to see a better result in EMEA. Okay. Second question is about your mobile business in China. Can you give us more colors on your strategy, on your ambition in your home turf? Because when we look at China mobile business, 2 years ago, Xiaomi was very successful with their online channel. Then this 1 year and 1 year half, we see Vivo and Oppo going very strong with their offline channel. So in this situation, this market, where do we stand in terms of Lenovo in this market? How we try can be more successful in your home country, given you already have a very good channel with your PC business? Yeah. Thank you. Regarding our mobile business in China, definitely, this business is still in the transformation period. So actually, our revenue declined significantly, and profitability is bad because we are cleaning up the inventory. So the edge of the product. We are trying to build the new channel, new business model. I would say by the end of this fiscal year, we would clean up all the edge of the inventory. We have the chance to start from scratch. With a new leader, Gina Qiao. She's very ambitious. She's willing to help the company to build a solid foundation in this business. But definitely, we need to start from rebuild the leadership team, rebuild the organization, rebuild the business model. We also need to sharpen our product competitiveness. We need to have a very solid branding strategy. But everybody here knows China market is the most competitive market in the world. Actually, almost all multinational brands cannot succeed in that market because some local players, definitely, they are very aggressive. The product definition is different from the other markets. So customers pay more attention to the price, to the price performance, et cetera. We must have different strategy, different product offering to address this market. That is what we have learned from this market. But this market still represents almost 30% of the total market. If you want to win worldwide, you must win in this market as well. This is not a market we can give up. We will never give up this market, but I wish you could know. We now start from scratch to rebuild the foundation, rebuild the core competence in this business. But it needs to take some time to see the result. Thank you. Thank you, Yuanqing. Thank you. Okay. Thank you very much. Thank you, everybody, for your participation in the call. If you have any further questions, please feel free to contact me or the IR team directly. The webcast replay and conference call replay will be available in a couple of hours. Thank you again for joining us today. Ladies and gentlemen, that does conclude our conference for today. Thank you for participating. You may all disconnect.