Earnings Call: Q1 2017

Aug 18, 2016

Good morning, good afternoon. Welcome to Lenovo's Q1 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, our Corporate President and COO, Mr. Gianfranco Lanci, and our 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, our industries remained challenging. The PC and the tablet markets declined, and the smartphone and the server were essentially flat year-on-year. The continuing currency fluctuations worldwide, especially RMB depreciation, also impacted our results. Yet, Lenovo still delivered a solid performance. Overall, although our revenue dropped 6% year-on-year, or 4% excluding currency impact, our PTI increased nearly 300% year-on-year to reach $206 million. If we excluding non-cash M&A accounting charges, our PTI would be $281 million, nearly twice as the same quarter last year. Our PC and the smart device business remains strong. We improved the profit margin by half a point year-over-year. All geographies gained share and improved profitability, except for EMEA. Our tablet business outgrew the market by 14 points and returned to number 3 worldwide. In fact, we are now the clear worldwide leader when you combine PC and the tablets. We will leverage industry consolidation to further gain share, and focus on faster-growing segments like detachable PC, gaming PC, Chromebook PC, to grow in revenue over time. In mobile, our turnaround strategy is delivering results. We are integrating the teams, not just optimizing cost structure, but strengthening cohesiveness and the consistent culture of the team. We are enhancing our product portfolio. In mainstream, we are optimizing cost and expenses to ensure competitiveness. We successfully launched the new Moto G4 and the ZUK Z2 models, and received very positive feedback from the market. In high-end, we are focusing on innovation. We launched the Moto Z and the Moto Mods in the U.S. in late July, and we are ramping in other parts of the world soon. These are game-changing products, and we are getting strong reviews from customers and partners, and good preliminary sales results in U.S. We are also expanding our channels and investing aggressively in marketing and branding. With these actions, we saw quite positive signals. Our mobile business revenue was almost flat year-to-year, only declining 1% if excluding currency impact. Quarter-to-quarter, our shipment increased by 3%, but revenue increased by 10%. This shows our mobile business is stabilizing and our transition to high-end products is really working, leading to higher average selling price and almost a three-point improvement in operating margin year-to-year. We kept a strong momentum in Asia Pacific, Eastern Europe, and Latin America. In data center business, while we still face challenges in U.S. and other mature markets, we strengthened our number one position in China and grew revenue 14% year-on-year there, driven by growth in hyperscale business. Another highlight is that our global accounts business grew data center revenue by 45% year-on-year. We will further strengthen sales capabilities worldwide, improve product cost competitiveness, particularly in hyperscale market, and increase attach rate of services and options. In addition, we will continue to build our capabilities in storage, networking, and hyperconverged technology. We believe innovation has always been the core to drive a company's future and the business growth. At Tech World in June, we unveiled the Phab2 Pro, the first augmented reality mobile device. We wowed the audience with a bendable phone and a foldable tablet concept or prototype product. We launched the Moto Z, which I mentioned earlier, and there is a snap-on Mods, which make your phone an outdoor theater, a portable stereo, a professional camera, a battery powerhouse, and perhaps even more. Just like we created a new category of convertible PCs with our Yoga a few years ago, we have now created another new category of snap phone. Lenovo does a lot more than just tinker and upgrade. We keep challenging the status quo and delivering the innovation that the industry has long been waiting for. At IFA in Berlin in September, we will showcase more one-of-a-kind innovations, so please stay tuned. In the long term, Lenovo is combining our traditional strength in devices with unlimited possibilities enabled by cloud. We are uniquely positioned to build our balanced device plus cloud model, connecting devices to cloud to create a seamless experience for our users at home, at work, or on the go. This is the direction that Lenovo is pursuing. Although the market and the environment may remain tough for the foreseeable future, we are seeing the results of our execution and are investing to achieve long-term growth. We remain confident in our strategy and our capability to achieve our vision and the goals. Now, let me turn it to our CFO, Weiming. Weiming, please. Thank you, Yuanqing. I will take you through Lenovo financial and operational performance in Q1 fiscal year 2017. Next chart, please. First, let me take a look at our quarter one highlights. The markets continue to be challenging, but we have seen progress in our business transformation, driven by our solid execution. Our group revenue recorded growth of 10% quarter-on-quarter to $10.1 billion. The year-to-year decline narrowed down 6% year-on-year as compared to 19% year-on-year in last Q4, or down 4% in constant currency. Our profitability also improved in quarter one. Group PTI, excluding the non-cash M&A related accounting charges, was $281 million, up 97% year-on-year. Reported PTI was $206 million, up 297% year-on-year. Group net income was up 64% year-on-year to $173 million. Next chart, please. Gross profit decreased by 7% year-on-year to around $1.5 billion, and our gross margin was 13.3%, showing a slight decline year-on-year, primarily due to change in our business mix. Operating expenses decreased by 17% year-on-year, and expense to revenue ratio was down 1.7 points year-on-year to 12.8%. This was due to our continued efforts to improve cost efficiency, and part of the expenses was offset from gains derived from our asset monetization exercise. As I mentioned in last quarter, we have begun to look for opportunities to monetize our non-core operating assets in order to free up capital for investing in our business. We have executed a sales and leaseback of one of our property assets. The transaction resulted in recording over $120 million in capital gains, which is shown in other operating income in our financial statements. We will continue to look for such asset monetization opportunities to fund some of our investment to drive our business growth. We recorded net other non-operating expenses of $39 million, which mainly included the interest expenses from the USD notes and the RMB notes we issued and the imputed interest expense for the promissory notes. Tax for quarter one was $38 million, with tax on the gain in relation to the asset monetization offsetting part of the tax credit associated with the two acquired businesses. Net income was $173 million, an increase of 64% year-on-year. Basic earnings per share for the quarter was $0.0157 compared to earnings of $0.0095 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 current assets were $13.2 billion. The major change compared to March end quarter was the increase in trade and OEM receivables and payables due to seasonality. The reduction of provision results from restructuring cost payment made during the quarter. Current liabilities were $2.5 billion. The non-current liabilities were $6.2 billion. Next chart, please. Cash flow from operations for the quarter was $8 million, against cash outflows of $310 million same quarter last year. In quarter one, we also recorded a cash flow from investing activities of $34 million, again, a cash outflow of $147 million last year. Decrease in bank deposits and cash was mainly due to the payment of restructuring expenses in the second half of last fiscal year, and interest expenses for the bond and promissory notes. We have a net debt of around $1.2 billion at the end of the quarter. We will continue to drive improvement in our balance sheet by reducing working capital requirements and rearranging part of the short-term borrowings into long-term facility, as well as looking for asset monetization opportunities. We continue to see improvement in our cash conversion cycle. In quarter one, it improved from positive five days last year to zero days this year. Next chart, please. This is the first report under the new organizing infrastructure we announced in early 2016, and the like-for-like comparison is on a pro forma basis. The pro forma historical data for the last fiscal year can be found in the appendix of this presentation deck. In quarter one, we continued to grow our worldwide PC market share and improve our share in every geography except EMEA. We recorded profit for our tablet business, with shipment growing at a double-digit premium to the market. As PC is our core profit-generating businesses, we will continue to enhance its profitability by balancing overall improvement in profitability and revenue growth. in Q1, we managed to not only grow the PCSD PTI year-on-year, but also improve the PTI margin by 0.5 points year-on-year to 5.3%. Our strategic shift is showing signs of positive momentum. Our smartphone shipments and revenue saw positive traction quarter-on-quarter. Our mobile revenue year-on-year decline narrowed to nearly flat for the quarter if excluding the currency impact. This compared to a year-on-year decline of 39% in the previous quarter. We recorded an operating loss before non-cash M&A related accounting charges of $163 million, against loss of $229 million same quarter last year. In China, we launched our ZUK Z2 series and have received positive market feedback. At the same time, we will increase our investment in branding and marketing in Q2 to prepare for the launch of our new products, Moto Z, as well as Moto Mods. Our business in PRC remains strong, with 14% year-on-year revenue growth, and we acquired new large global accounts, leading to the revenue going up 45% year-on-year. The North America and EMEA business remain relatively slow, as we are still investing in product portfolio and building our sales force. The Data Center Group thus recorded 1% revenue growth year-on-year for the quarter, or up 4% if excluding currency impact. With our ongoing business transition of our data center business, along with the keen competition in the hyperscale business in China, we recorded an operation loss of $31 million for the fiscal quarter one before non-cash M&A related accounting charges. Next chart, please. China. Total revenue for China was $2.9 billion, down 10% year-on-year, partly due to the translation impact from the soft RMB, while we upheld our PTI margin flat year-on-year at 4.8%. We continue to uphold our strong PC profitability in China by leveraging our leadership position despite the market challenges. The mobile business has begun to shift our portfolio to mid to high price bands and improving user experience, while the successful launch of the ZUK Z2 model received good initial market feedback. China data center revenue grew at 14% year-on-year, a premium to the market, and supported by growth from hyperscale and contribution from the new partnership approach. For Asia Pacific, revenue was up 4% year-on-year to $1.7 billion in Asia Pacific. The Asia Pacific business saw continued PC market share gains, up 0.4 points to reach 16.4%. The mobile business outgrew the market in key countries, including India and Indonesia, while the Data Center Group continues to work on improving profitability. The growth was mainly supported by strong smartphone shipments, especially in ASEAN countries and India. Operating margin was on recovery track and improved 0.2 points quarter-on-quarter. EMEA. EMEA revenue was down 7% year-on-year to $2.5 billion, and we recorded an operating loss in the quarter. The decline mainly is a reflection of severe market softness and currency depreciation, which particularly affected our PC business. We took actions to improve channel inventory to address challenging conditions and return for future growth. Mobile saw traction over the previous quarter as a result of new products coming to the market. The data center business remained challenging with the year-on-year revenue and margin decline. For Americas. Americas revenue was down 7% year-on-year to $3 billion. PC market share was up 1.4 points year-over-year to 15%, driven by strong growth in North America and improvement in Latin America, especially Brazil. Mobile shipments declined in North America due to product transition, but stabilized in Latin America. The data center business worked on building the right sales model while strong competition put pressure on the business. Operating margin for Americas thus improved to 1.3% this quarter from a loss position last year. Looking ahead, the markets we are in remain challenging, and we will continue to take actions to improve performance of each of our businesses. In the short term, there are signs suggesting the PC market will stop declining significantly, and we see growth opportunity in detachable gaming PC and Chromebooks. We were aggressively targeting certain growth product categories, example, the two-in-ones, the workstation, and gaming, to drive growth. At the same time, we have taken actions to address the challenges in India arising from the soft market and operational issues. On the smart device side, our Phab2 Pro, as the world's first AR-capable smart device, will soon be coming and has already attracted lots of attention. While our competitive cost structure will continue to take advantage of market consolidation and attack growth areas in the expanded PC market. We expect to continue to outperform the market while maintaining our margin performance. For the Mobile Business Group, our transformations have already started showing some progress in Q1, and we will continue executing our plan to get mobile business back to growth with improved profitability. We have launched Moto Z in Q2, which has received initial positive market feedback, and we will continue to invest in branding and distribution to build up the sales momentum. For data center business, we have reorganized our structure to sharply focus on the markets and continue to enhance the end-to-end capabilities and ownership for everything from innovation through operation and technical support. We are expanding the solution portfolio with our innovation and integrating partner technologies to compete in a larger percentage of the total market opportunity. in August last year, we execute a series of business realignment actions with an objective in taking out $1.35 billion operating costs to enable the group to focus resources, sharpen its business model, and efficiently capitalize on most attractive market opportunities in mobile, PC, and data center. Execution of these actions have been on track, and we have overachieved the $1.35 billion target over the last four quarters. We have taken actions to drive sustainable growth and profit improvement, although this action will take time to see result. Meanwhile, 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 positive growth and increase shareholders' return over time. Thank you. Now we can take your questions. Thank you, Wong Wai Ming. We now proceed to questions. We want to accommodate as many questions as possible, so please avoid multi-part questions and limit to just two questions at one time. Please say your name and name of the company before your questions. All the questions will be in English only. Operator, would you please give us your instruction? Thank you. We will now begin the question and answer session. If you wish to ask a question, please press star one on your telephone and wait for your name to be announced. Our first question comes from the line of Gokul Hariharan from J.P. Morgan. Please go ahead. Yeah, hi. Thanks for taking my question. Just on the smartphone side, could you talk a little bit about the China strategy, especially going with ZUK, given that we are seeing that the online channel is starting to decline meaningfully this year, while the offline channel is starting to pick up. At least my understanding seems to be that ZUK is at least predominantly been an online approach. Could you talk about the strategy there? Thank you. ZUK is just focusing on China. Let me talk about our worldwide smartphone strategy first, then come back to the ZUK and the China. Our worldwide smartphone strategy is clear. We will focus on three things to improve. The first is we will thoroughly integrate Motorola and Lenovo team and organizations so that not only we can have the better cost structure part, we can be more efficient and cost competitive. But also, we can form the cohesive team and the consistent culture. That's the first point. The second point is, we will enhance our product portfolio. We will separate the mainstream and the premier products. The mainstream, we are optimizing our cost and expenses to ensure the competitiveness. As you just said, we successfully launched the new Moto G4 and the ZUK Z2 models last quarter and received very positive feedback from the market. Definitely, Moto G4 is for worldwide, and ZUK Z2 is for China and some selected Asian countries, India eventually. In the high end, we are focusing on innovation. We launched the Moto Z and the Moto Mods in U.S. late July, and we are ramping up in other parts of the world very soon. I believe this is a game-changing product, and we are the first company to launch this kind of modular phone so that we can significantly enhance the feature of the smartphone. We have got very positive reviews and feedback from customers and from partners. The preliminary sales results are also very good, very positive. This is about the product. The third thing we are focusing on is expanding our channels and investing aggressively in marketing and branding in key countries, including China, U.S., Germany, et cetera, so that we can strengthen the brand image, brand awareness, and can have more channel coverage. In China, we are strengthening our relationship with Suning and JD.com. In the U.S., in the past, we relied on Verizon. Now we have expanded into Best Buy. Soon we will expand into Costco as well. That's about the channel expansion. In China, you just said, right. We launched the ZUK to focus on the mainstream price band. We have seen very positive feedback from the market. Actually, our average selling price last quarter in China significantly improved. Actually, we dropped many low-end products and shifted focus to the mainstream and the premium. Very soon, we will launch our Moto Z and Moto Mods in China, probably in September. That will help us to strengthen our high-end premium price band. In China, regarding our product portfolio, we have a very clear strategy. We will use Moto to cover the high-end premium price band. ZUK will be the mainstream. Actually, we have another sub-brand, a product brand called Lemon to cover the entry-level product. Actually, all the products will cover all the channels. You are right. Actually, the online channels now in China are not the dominant channel. I would say it's back to the normal. Actually, online channel only accounts for 20%-30% of the overall market. Probably open market accounts for more than retail channels account for more than 50% market than less than 30% the carrier market. All Lenovo products, no matter it's Moto, it's ZUK, it's Lemon, will cover all three channels. That's our strategy. Right. Thank you. Our next question comes from the line of Arthur Hsieh from UBS. Please go ahead. Thank you. Congratulations on the solid results. I have two questions. The first question is on the PC business. You have shown great progress, but the gap to the follower has actually narrowed. How do you see the demand outlook and the competition, and the channel inventory situation? I will invite our COO, Gianfranco, to answer the question. Gianfranco, please. Yes. The gap has been narrowing because if you look, our premium is down to 2%-3%, so below the 5%. As we said, it is mainly coming from EMEA in the sense that if you look at all the other geos, we are gaining share with a good premium. Very good in U.S., strong in China, and also good in all the other geos like Latin America and Asia Pacific. In EMEA, we are facing, on one side, some tough market condition or let's say, very strong price war. On one side, we also face some operational issue on the other side. We are fixing it. I think that already this quarter, we will come back to a much better premium to market. The market is slightly stabilizing, I would say. When we look at the market overall, I think it is still negative in terms of growth. But still, the negative growth is slowing down. We are working in order to fix the operational issue we have seen in EMEA. But we are quite confident on all the other regions. Another good thing is that when we look at our Brazil result, that it was, I would say, a little bit disappointing last year. We are almost running at breakeven now. We also start to see in Brazil, with Olympics and some other things, the market slowly coming back. I would say for Q2, we are much more confident that we can come back to good premium to market. We can also come back to enlarge the gap with the competition. Even though when you look at the rush to consolidation, I think it's clearly that all our major competitors, being HP or Dell, they are also trying to see how they can leverage consolidation. We continue to see all the other players on the other side getting in trouble or losing share. Another important thing is that when you look at our result, we are always very careful on balancing profitability and share and growth. When you look at PCSD, we have been improving margin by 25%, so we are running with 5.3%. That is, I think, by far the best in the market. I don't think there is anyone else able to do the same. Yes. We will continue to balance growth and profitability. Yes. Basically, we performed strongly in all geographies except for EMEA. In our other four geographies, North America, Latin America, Asia Pacific, and China, we are gaining very decent shares, and also we improved profitability. We improved the PTI ratio. Particularly North America is very impressive. Actually, in PC, we grew by 13%. In tablet, we grew by almost 70%, 70%. So our profitability in North America improved by 1.1 point. So now it's the second best geographic in Lenovo. That's pretty encouraging. Thanks, Yuanqing. Next question, please. Thank you. Our next question comes from the line of Leping Huang from Nomura. Please go ahead. Leping from Nomura. Hello? Please go ahead with your question. Yeah. Thank you for taking my question. I have two questions. The first question is about the accounting. You recognize $100 million, when you say $100 million gain from asset sale at bank. Can you explain more detail on this transaction, and which segment actually you recognize this, the gain from this leaseback? Will you continue for this to improve the efficiency of the asset? Thank you. Yes. We will continue to look for opportunities to monetize our assets. I think the one that we executed in quarter one was one of our buildings in Beijing. I think this is actually a sales and leaseback transaction of our office buildings because we actually have three office, I think campuses in Beijing. The item was actually recorded in other operating income show expenses item in the balance sheet, I think in the P&L items. If you go through it, I think it was there. We will continue to look for, I think opportunity to further monetize our assets, I think to continue to improve, I think the cash so that we can actually invest such cash into our operations. Thank you. Thank you, Lebing. Next question, please. Our next question comes from the line of Thompson Wu from Credit Suisse. Please go ahead. I just have two quick questions. The first question is, Yuanqing, you talked a little bit about the challenges in the U.S. market with your Data Center business. Can you just share with us what Lenovo is doing to address these challenges? Yes. Because our sales coverage is not enough and our sales capability is limited. We do see some challenging in U.S. Actually, last quarter, our Data Center business declined by 7% in U.S. Because the sales scale is different to sell a data center than to sell PC. Actually, PC, we sell to the procurement department. But for Data Center business, we sell to CIOs. We definitely needed to strengthen that capability. But the good news is, our global account team is doing very well. Not only are they selling PC well, but also they are selling Data Center business very well. Last quarter, we grew our Data Center business with the global account by 45%. 45. By 45%. That means we have the knowledge, we have the skill in that part of the customer. We just needed to replicate our success to North America, to EMEA, to the next level of the enterprise customers. We need to strengthen the scale in North America and EMEA. That's the current situation. Right. Thank you. Our next question comes from the line of Wei Cheng from Goldman Sachs. Please go ahead. Yeah. Thank you. Just have a follow-up on the smartphone business during the quarter. We saw revenue going up sequentially, and I think it was explained as the focus was more on high ASP products, so more on the high-end revenue. In terms of volume, it was actually flat too. So it is basically driven by higher ASP products. But when we look at the profitability, actually, the losses declined wider sequentially. So how do you have higher-end products selling more and still having the losses increasing? This is the first question. Thank you. Your question is? So what are they- For the MBG, can you explain how the losses increased sequentially? MBG loss increased in Q1. Q4 versus Q1. Q1 versus Q4. No. So actually, our Q1 loss is less than Q4 last fiscal year. That is Q1. Carry on. I just want to make sure we actually get your question right. So I think we recorded our mobility business losing $163 million in Q1, versus Q1 last year was $229, but Q4 is $79. Is your question why was Q1 showing a bigger loss than Q4? Wei, is that your question? I think this is the question. Operator, are you there? Yes. Hello? Can you hear me? Yes. Wei, could you repeat your question again? Why have the losses for MBG increased sequentially? 1Q versus 4Q last year. Why the Q1 operating loss is bigger than Q4? Yeah, the PTI losses. Yeah. The PTI loss. Oh. Yeah. I think Q1 versus Q1 will obviously improve. I think executing the strategy does not actually happen in one quarter, because we still need to clear some of the channels, some of the inventory. You definitely see that we are selling more high-end phone or high-priced phone. For example, in China, we are moving out from the low-priced product in the higher-priced product. But on the other hand, you actually see, as a result of that, our volume actually sort of coming down as well. So I think when we're sort of slowly executing that strategy, you will actually see that happening. But on the other hand, if you really look at the year-to-year, we actually continue to further benefit by our cost reduction program that we announced about 12 months ago. So you actually see expenses also come down, resulting in actually an improvement year to year. So that is really a combination of transitioning from the previous low-priced product to a higher-priced product. Right. Thank you. Thanks, Wei. Next question, please. Thank you. Our next question comes from the line of Arthur Lai from CCB International. Please go ahead. Hi, this is Arthur Lai from CCB International. Thanks management for taking my question. I guess the other area is also important is DCG. I have two questions. One is a housekeeping question to Weiming, and the other is the forward-looking question to Wai Ming. On the first question, if we look at the DCG PTI, actually it swung a lot. Sequentially, it actually declined about $48 million. The revenue actually is up 10% sequentially. Can Weiming share with us what is the driver of this change? That is my first question. All right, Arthur? Yes. You are talking about the DCG part, right? Right. Okay. Yeah. I think the financial is obviously the I think our China business continues to do well. I think China on a year-to-year basis is still growing 14%. I think the real driver of the financial result is the rest of the world. I think our revenue actually is coming down. But the increase in revenue in China, a lot of those really derive from the hyperscale business. As a result, those incremental business probably does not necessarily carry a very high margin. Arthur? Thank you. Due to time constraint, we are going to take the last question. Thank you. Our last question comes from the line of Grace Chen from Morgan Stanley. Please go ahead. Thank you, Yin Ting and Wai Ming for your presentation and taking my call. I just have one clarification. You look at the Q1 segment profits. I added them up. It was $139 million. This is operational level compared with the fourth quarter last year was $240 million. It was down sequentially. But when we look at the bottom line, the PTI numbers, it was up sequentially. Should I attribute the key differences, the discrepancy amount to the $120 million of capital gains coming from the disposal of assets? Grace, I think this total profit obviously also include the capital gain coming out from monetization assets. I think you are right. That number, as I explained earlier in the call, you can actually see that number, I think recorded in our other operating income sort of expenses, I think notes there. If you look at our financial statement, it was included in that. Okay. Thank you everybody for your participation in today's call. If you have any further questions, please feel free to contact me or the IR team directly. This is a webcast we play and conference call replay will be available in the next couple of hours. Thank you again for joining us today. That does conclude our conference for today. Thank you for participating. You may now disconnect.