Earnings Call: Q2 2017

Nov 3, 2016

Good morning. Good afternoon. Welcome to Lenovo's Quarter 2 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, Executive Vice President and CFO, Mr. Wong Wai Ming. We will first start with a 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. Last quarter, market conditions remained challenging. Both the PC and the tablet markets declined year-on-year, while smartphones saw only modest growth. Yet, in spite of this, Lenovo delivered a solid performance. Overall, while our revenue dropped 8% year-on-year, we grew 12% quarter-to-quarter. Our reported PTI was $168 million. If you exclude one-time actions, our PTI increased 7% year-on-year. Our PC and smart devices business had another strong quarter. Our PTI margin increased by more than half a point year-on-year. In North America, we outgrew the market by more than 15 points year-on-year with a strong PTI margin of 6.6%. Our focus on faster-growing segments delivered good results. In gaming and detachables, we grew 36% and 52% year-on-year respectively. In addition, we focused on millennial PC users, and the Always Online, Always Connected feature was well-received in China, growing over 200% year-on-year. We see big potential to expand to other parts of the world. All of these were driven by great products. Even more, we keep innovating. The Yoga Book we just launched is a one of a kind product that wowed the industry. And the award-winning Yoga 910 and Yoga Tablet 3 Plus show we continue to bring innovation to the convertible and the tablet segments. Overall, we strengthened our number one position worldwide with PC and tablet combined. We will maintain leadership and a strong profitability through leveraging industry consolidation, launching innovative products, and focusing on faster-growing segments and vertical markets. In mobile, over the last 18 months, we have taken many actions. We formulated a clear strategy, integrated our brands, built a united team and a consistent culture, and significantly drove costs down with two restructure. We have saved almost $1 billion run rate expense, which allow us to invest more in innovation, in products, marketing, and branding to drive the growth. These actions have brought steadily improved results. Our mobile business operating margin improved by four points quarter-to-quarter, with ASP up 18% year-on-year. Our smartphone volume grew 25% quarter-to-quarter, driven by strong Moto volume growth of almost 40% quarter-to-quarter. And we've gained share quarter-to-quarter by six tenths points. In every geo, we outgrew the market and improved share quarter-to-quarter. We are on track to turn around this business in the middle of next year. Our better performance was also driven by our very successful Moto Z and Moto Mods launch. The first step sales results came in quite encouraging, particularly in North America and Latin America. We ramp up to almost 60,000 units per week globally. As a new category, its momentum is comparable to iPhone during the first 3 months of launch. In U.S., almost 30,000 units a week. Even in Mexico alone, we are selling almost 10,000 units a week and quickly surpassed Apple to become the number one in AT&T's premier segment. We expected to sell 3 million units in the first 12 months, which would represent a very strong launch for this new category of modular smartphone. In data center business, the bright spots are China and the global accounts. Their revenue grew 7% and 16% year-on-year respectively. We clearly understand this business is still in the middle of the integration and the transformation, as our revenue and margin both dropped the last quarter. This is mainly due to our insufficient direct sales and channel capability in some regions. Besides, our product offering was still transitioning from server-centric to hyper-converged and software-defined solutions. That also impacted our short-term results. I want to say, we remain believe data center business is a very attractive business, and we are still fully committed to it. We are taking actions to fix this business model and build our core competence, strengthening direct sales and channel capability on the front end, and improving competitiveness of our products and the solution offerings. The leadership change, which I will discuss shortly, will also help getting this business back to profitable growth. As our business has become more diversified, we will clearly realize that our past experience, capabilities, and talents are not enough to support the growth of multiple businesses. We need to keep attracting the industry's top minds to ensure our success in new businesses. I am glad to announce that Dr. Ray Yong from Azure Lab of Microsoft has joined as Chief Technology Officer. Kirk Skaugen, a industry veteran, former SVP Intel, will join Lenovo as President of Data Center Group. Laura Quatela, former President of Eastman Kodak, has joined as Chief Legal Officer. All 3 are deeply respected experts in their fields and proven leaders with a passion for technology and innovation. To continue strengthening execution, Gerry Smith, with his knowledge and experience in operations, will run our global supply chain for all our businesses. Xudong Chen will lead Global Services following Xiao Yan Wang's retirement. Gina Qiao, with her deep expertise in strategy, in people, and in marketing, will lead the mobile business of China. Gao Lan, a highly experienced HR leader, will step in to assume HR leadership role. For more details, please refer to our press release. In summary, market conditions may remain tough in the short term, but we were seeing the results of strong execution. We are confident in our vision, in our strategy, and in our leadership team. We are investing to achieve long-term profitable growth. Now, let me turn it to our CFO, Wai Ming. Wai Ming, please. Thank you, Yuanqing. I will take you through Lenovo's financial and operational performance in Q2. Next chart, please. First, let us have a look at our Q2 highlights. Our group revenue continued to stabilize and record growth of 12% quarter-on-quarter to $11.2 billion. However, revenue declined 8% year-on-year due to the continued challenging market environment and currency impact. If excluding currency impact, the revenue declined 6% year-on-year. During the quarter, we executed a resource action to improve operating efficiency and expect a potential run rate expense savings of $337 million, against the redundancy cost of $136 million incurred in Q2. Meanwhile, we also recognized a capital gain of $218 million from the disposal of property and other assets. Group PTI was $168 million, against a pre-tax loss of $842 million from last year. This would exclude the net benefit of $82 million resulting from netting off the redundancy cost and capital gain, as mentioned earlier. Operating PTI would be $86 million, up 7% year-on-year. Group net income was $157 million, against a net loss of $740 million from last year. Next chart, please. Gross profit increased by 2% year-on-year to around $1.6 billion, and our gross margin was 14.3%, up 1.3 percentage point year-on-year, primarily due to better product mix from our smartphone business. Operating expenses decreased by 41% year-on-year, and expenses to revenue ratio was down seven percentage point year-on-year to 12.4%. This was due to our continuing efforts to improve cost efficiency, and part of the expenses were offset from net gain derived from our asset disposal, as I mentioned earlier. On a like-for-like comparison, our run rate operating expenses decreased by 6% year-on-year. We recorded net other non-operating expenses of $47 million, which mainly included the interest expenses from our U.S. dollar notes and RMB notes we issued, and the included interest expenses for the promissory note. Tax charge for Quarter 2 was $16 million. This includes tax on the disposal gain in relation to the sale of property, offsetting part of the tax credits associated with the two acquired businesses. Net income was $157 million, against a net loss of $740 million from last year. Basic earnings per share for the quarter were 1.42 U.S. cents, compared to losses of 6.43 U.S. cents last year. 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. The change in our balance sheet mainly reflects our business activities during the quarter. Non-current assets were $12 billion, and our current assets were $15 billion. The major change compared to June end quarter was the increase in trade and OEM receivable and payables, both of which is primarily due to seasonality. Net current liabilities were $2.7 billion. The non-current liabilities were $6 billion. Next chart, please. Cash flow from operation for the quarter was around $1.6 billion, which improved significantly both year-to-year and quarter-to-quarter, thanks to a better cash conversion cycle from receivable collections efforts, inventory management, and improved payment terms. Increase in bank deposits and cash quarter-to-quarter was mainly due to strong cash flow from operation. We have a net debt of around $77 million at the end of the quarter. We will continue to drive improvement in our balance sheet. We continue to see improvement in our cash conversion cycle. In Q2, it improved from negative 1 day last year to negative 5 days this year. Next chart, please. PCSD. In Q2, we continued to grow our worldwide PC market share, and we caught strong margins in PRC and North America. With our strong tablet shipment growth in China, we continue to stay as the leader in the PC plus tablet market. PCSD remained as a solid profit pool to the Group, and we further improved our PTI margin by 0.6 percentage point year-on-year to 5.2%. Mobile business growth. Strategic shift in our mobile business continues to show signs of positive momentum in quarter 2. Our smartphone shipments and revenue continue to show strong traction quarter-on-quarter, with 4 percentage point profitability improvement, driven by successful launch of Moto Z and Moto Mods, strong shipment from Moto G, and strategic shift to drive higher price band products across the board. We recorded an operating loss before non-cash M&A related accounting charges of $114 million. Again, loss of $163 million loss in Q1 and $175 million same quarter last year. We have recently taken resource action to further align our organizational structure and streamline product portfolio. This will help further to sharpen our competitiveness in the global smartphone market. Data Center Group business growth. Our Data Center Group business in China and Latin America both have strong revenue growth year-on-year in Q2. We see encouraging achievements in our global account customers, which recorded another quarter of strong growth. We have started our hyperscale business in North America, and we won new customer from next generation IT segments. Although we continue to invest to build our direct sales and channel capability to expand our sales coverage, our businesses in North America and EMEA remain relatively slow. As a result, the Data Center Group business recorded 8% revenue decline year-on-year, and operational loss before non-cash M&A related accounting charges worsened to $108 million in Q2, compared to a loss of $31 million in Q1. As Yuanqing mentioned earlier, we will continue our investment in this business to drive growth and take further actions to improve efficiency. We expect our DCG business will start showing improvement in the coming quarters. Next chart, please. China. Total revenue from China was $3.2 billion, down 4% year-on-year, mainly impacted by our business transition in smartphone while our PTI margin grew 0.8 percentage point year-on-year to 4.9%. We continue to uphold our strong PC profitability in China by leveraging our leadership position despite the market remains slow. The mobile business continued to focus on our channel expansion and portfolio shift to mid to high price band, demonstrated by the year-on-year ASP improvement. China Data Center Group revenue grew at 7% year-on-year, supported by growth from hyperscale and contribution from the new partnership approach. Asia Pacific. Revenue was down 4% year-on-year to $1.9 billion in Asia Pacific, mainly due to slow PC market in the region and the Indian mega education deal last year. The mobile business continued its strong momentum in India, while the Data Center Group continued to work on improving profitability. The operating margin drop, both year-on-year and quarter-on-quarter, was mainly due to a weaker PC business in the region. EMEA revenue was down 14% year-on-year to $2.7 billion, and we recorded an operating loss in the quarter. The decline is mainly from the challenges of our DCG business, as well as additional spending to clear our PC inventory during the quarter. Americas revenue was down 7% year-on-year to $3.4 billion. PC market share was up 1.6 point year-on-year to 15.4%, driven by strong growth in North America. Mobile shipments continued to show positive traction quarter-on-quarter. The Data Center business started its hyperscale business and had made progress in global account customers during the quarter. With a stronger PC business and improvement in the smartphone business, PTI margin for Americas region improved from negative last year and turned to positive 0.6% this quarter. Looking ahead, we will continue our focus on executing the actions to improve performance from each businesses. For PC, there are signs suggesting that the PC market continue to narrow its decline. We remain confident to maintain our leadership and strong profitability in our core PC business, leveraging the market consolidation and the success in fast-growing product segments. On the other hand, we will continue our efforts to build Mobile and Data Center business into new profit engine. Through the series of action Yuanqing mentioned, we stay confident for driving mobility continuous revenue improvement, and turning around the business in next fiscal year. For DCG, we believe Data Center is an attractive business, and we're fully committed to this business. We will continue to expand our sales coverage through building stronger direct sales and channel capability, provide competitive product and service offering, and build partnership with industry leaders. Those actions, we need some further investment in the second half to ensure our Data Center business back to profitable growth over time. Although the general market environment will remain challenging in the near term, with new and strong leadership team we announced today, plus our actions in place, we believe we can continue to drive sustainable growth and profit improvement. Although this action will take time to see results, we will continue to invest in areas we believe are important to our future success. We remain confident that Lenovo can outperform the industry to drive profitable growth and increase shareholders' return over time. Thank you. Now we can take your questions. Thank you, Wei. Now we proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and limit it to two questions at one time. Please state your name of company before your question. All the Q&A will be in English only. Operator, would you please give us your instructions? Ladies and gentlemen, we will now begin the question and answer session. If you wish to ask a question, please press star one on the telephone and wait for your name to be announced. If you wish to cancel your request, please press the pound or the hash key. Our first question comes from the line of Ken Hui of HuaXie. Please go ahead. Thank you for taking my question. My first question is obviously on DCG. I think Wei just commented the business still needs some investment in near term. Should we expect the loss to expand in the coming one or two quarters? When you set improvement, it is more coming from the scale improvement or coming from the cost reduction, and do you have a plan on when to turn around the business? Thank you. Thank you, Ken. We think we still need to do our investment on the Data Center Group business. In two aspects. The first is in the front end. We need to significantly strengthen our sales coverage so that we can directly sell to the end users, larger enterprise customers. When we acquired this business from IBM, actually, we only got the second tier of sales. IBM has the first tier of sales, which manages the customer relationship. The second tier, they are called the brand sales. They sell a different product or service to the certain customers. We realized that we only have this second tier of sales, is not enough. We try to leverage our PC sales force to sell server business. There is definitely a limited effect. Actually, when we sell PC, we sell to the procurement department. When we sell the server, we need to sell to the CIOs. We need to build this capability. That means that we need to further invest in the sales area. Fortunately, I think it's not too difficult to get that kind of talent now. We are definitely doing our best to speed up the investment in that space. Another area is definitely the back end. Definitely the market is transitioning from the traditional IT to the new IT. We need to significantly strengthen our product offering. We need to transition from the traditional server part to the converged and the hyper-converged product, software-defined storage, software-defined networks. We must further invest in this area. I definitely believe we need to invest more in these two areas. Thank you. Thank you. My second question is on MBG. Obviously, since last year, you have done a fair amount of restructurings already. Can you update us how many employees you still have at Motorola? Particularly, how many R&D staff that you still have? If the number has been reduced, would you be concerned about product development in the future? Yeah. I think we still have more than 1,000 R&D engineers based in Chicago. But in the future, they will be focusing on the premier products. We definitely will shift the resources to China, focusing on the mainstream and the low-end product, like Moto G, Moto E, or other new product. That's our plan. Okay. I think since one year ago, we have completely integrated organization, integrated product portfolio. We have the plan to integrate the brand as well. Now we sell two brands, Moto and Lenovo. Over time, we will have only one brand. Lenovo is the company brand, so Moto will be our smartphone brand. That means on each of the Lenovo smartphone, you will see Lenovo Moto. Based on this branding strategy, we will have a united product portfolio. That will be very clear. We definitely need to further invest on the branding, on the marketing. But now on, I think that will help us to save the money. Okay. Thank you. Thank you, Sam. Thank you again. Next question, please. Once again, if you wish to ask a question, please press star one on the telephone and wait for your name to be announced. Our next question comes from the line of Jenny Lin of HSBC. Please go ahead. Sorry, this is Jenny Lin. I have two questions. The first question is regarding to Mobile Business Group, MBG. It's been a while since we started the restructuring. The ASP increase is actually quite encouraging. Should we expect the ASP continue to increase that will offset the pressure on the volume, meaning the breakeven volume will be much lower than what we expected before? Yes. You can expect the ASP further increase. Actually, we almost dropped all the low-end product in China with the carriers. That's the key reason to drive the ASP up. We will continue to do that. Also, definitely, ASP is driven by new product, by our innovative product, Moto Z and the Moto Mods. The first sale result is pretty encouraging. By now, we have shipped more than 1 million units of the Moto Z. By September, the Mods attach to it is around 60%. If you view this as a new category, you benchmark it with the iPhone first year or first three months. Definitely, we are on a similar track trajectory. Our activation volume ramped up to 60,000 units per week recently. 30,000 in U.S. Even in the market like Mexico, our activation volume reached 60,000 per week. That's pretty encouraging. Actually, AT&T is the most important partner of iPhone. In Mexico, we surpassed the iPhone to become the number 1 partner of AT&T. That's pretty encouraging results. If you look at our last quarter results, in almost every geography, we grow share. That proves not only this business is stabilized, but also we resumed the growth. Definitely, I believe, we can pursue the profitable growth over time. Starting from the rest of the world. Definitely in China, we still need to take some time to turn that around and to pursue the profitable growth. Thank you. Thanks. Our next question comes from the line of Gokul Hariharan from JP Morgan. Please go ahead. Yeah, hi. I have two questions. First, on the PC side. The last couple of quarters, the gap between Lenovo's PC growth and industry growth have narrowed. I think we historically were at about 5%-10% premium to the industry growth. Any thoughts on what is happening there? Is it because of mix shift geographically? Is it because of mix shift between segments? When do we expect to get back to that 5%-10% kind of premium in terms of the market growth? That's my first question. Second question, just wanted to dwell on the points Jenny raised, as well a little bit on mobile. After the recent restructuring actions, could you give us some indication on whether a revenue scale or volume scale, maybe revenue scale is easier given ASP is going up, where the mobile business, MBG business, will become break-even, and any kind of time frame on that? Thanks. Okay. Regarding the PC. Yeah. So definitely, given this is a mature business, we prioritize the profit first. We need to ensure we have enough profit to fund our growth in the other two businesses. That's our strategy. Definitely, if you want to maintain 5-10 points of premium to the market, probably you have to sacrifice some profitability. That's not what we want to do. Some of our competitors are pretty aggressive because they're a private company now. Probably the cash flow is more important than the profit. We don't want to have that kind of unreasonable competition. That's one thing. Definitely, in the last quarter, we had some operational issue as well. I think, yeah, we are fixing that. Hopefully this quarter, we could fix this issue to still keep the premium to the market. But generally speaking, I'm confident on our competitiveness in the PC space. I think we are very efficient. We have very efficient business model in that area. Even in this declining market, in this sales competitive market, we still keep more than 5% GDPR. That's very impressive. Another reason is in India, in Asia Pacific. Last year, we had a big deal. We call it the airport deal. Actually India education deal. That deal accounts for a big portion of the last year performance. Probably that's the little bit impact on the volume this year, on the year-on-year growth. That's about the PC. Regarding the MBG, I talked about that already. We are actually very encouraged by the progress we have made. I think now our product portfolio are very competitive and also are very innovative. Not only we drive the ASP up, but also we drive the gross margin up. We plan to turn around the business in the middle of the next fiscal year. After that, we will pursue the profitable growth. Actually, last quarter, we surpassed Xiaomi and LG to become the number six player in the world. Definitely, it's on track. Some of you still remember how we become the number one in PC. I hope that we could replicate another success in the smartphone area. Hopefully every quarter we could grow this year. We could surpass our competitors one by one. That's my expectation. Thank you. Due to time constraints, let's take one question. Our next question comes from the line of Thompson Wu of Credit Suisse. Please go ahead. Hi. Thanks, and good evening. Two quick questions on the PC business, specifically. It seems like your corporate business has picked up in the past few quarters. We're seeing some year-on-year growth. Could we just talk a little bit about the dynamics that you're seeing in your corporate PC business? The second question is, I think Maya talked about a slowdown in the AsiaPac PC business. Looking at some of the data that we have, it seems like declines there dropped off in the third quarter. Could you also talk about dynamics going on in your AsiaPac PC business? Yeah. I think, definitely. First, the commercial PC or corporate PC business is more stable as a consumer business. Commercial customers still needed to replace the PC even though the replacement cycle become longer. But, probably this is the end again at least 4 to 5 years that they need to replace. Lenovo is more competitive in the commercial space with our legendary ThinkPad brand, Think brand. Actually we maintain very good margin in that business, particularly in the global account, so multinational companies. I think we are very happy. We grow faster in that. We even grow in that space. That is about the commercial. Actually, even the entire consumer market is declining, but we try to find the new category to grow. As I talked at my opening, some specific category, so two-in-one detachable PC, gaming PC, millennial PC, Chromebook. We all grow faster and grow premier to the market, like two-in-one, 62% year-on-year. Gaming PC, that is 60% year-on-year. Chromebook, 70% year-on-year. millennial PC, 200% year-on-year. I think that will be our direction. We will drive this specific category to grow. Probably in the future, those kind of general purpose consumer PC will lose the market. This specifically used PC will grow this year. PC. I think on the Asia Pacific, it looks like that. I think our growth rate is not that good as what we would want, but I think if you really look at the top line, I think the base I think probably was high last year because we actually get the Indian education deal, which actually come in Q2, and therefore we actually have I think quite a high base. Now, if you actually take that out for comparison purposes, because this year, due to this year, there is no, I think government deal, I think we actually been increasing market share as well. So the AP may be on the numbers year-to-year growth a little bit slower, but the underlying is actually quite respectable. Okay, great. Thank you. All right. Thank you again for your participation. If you have any further questions, please feel free to contact the IR team. Thank you again for attending today. Thank you. Thank you. Bye-bye. Ladies and gentlemen, that does conclude our conference today. 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