Idea of the Week: PC Industry Leader Lenovo Yields Over 5% - Potential Refresh Cycle Post-Pandemic?

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Highlights:

Company Background

Lenovo Group (Lenovo) was established in 1984. It is a global computer equipment manufacturer. The company's business includes personal computers and intelligent devices, data infrastructure, and solution services. Currently, Lenovo is listed on the Hong Kong Stock Exchange (stock code: 992.HK) with a market value of approximately HKD 112.5 billion.

Since the 1990s, Lenovo has already dominated the Asia-Pacific region in the personal computer (PC) market. It then became an international enterprise within ten years after acquiring IBM's personal computer business in 2005. It has now become the world's largest PC vendor based on shipment volume.

As of the year-end 2023, Lenovo holds a 23% market share in the global PC market, making it the industry leader. In comparison, HP and Dell, which are also key market players, have market shares of 20% and 15% respectively (See Chart 1).

Chart 1: Global PC shipments market share

Declined Global PC Demand after the Pandemic Boom but the Industry Still Has Areas of Growth

The pandemic has led to an increased demand for PC as more people were working and studying from home. In 2021, the global shipment volume of personal computers reached approximately 350 million units, representing a rapid growth of 31% compared to 2019 (See Chart 2). However, after the initial surge driven by the pandemic, the PC shipment volume dropped by 34% to around 260 million units, returning to pre-pandemic levels, indicating a slight decline in overall demand.

Chart 2: Shipment volume of global personal computers

Although the PC industry is relatively mature, there are still areas of growth within the industry. One highlight is the emergence of AIPC which is PC with generative artificial intelligence (AI), and AI-related infrastructure. According to Canalys, a global technology market analysis company, AIPC is expected to become more prevalent in the next four years. The penetration rate of AIPC (in proportion to the total number of PCs) is projected to increase from 10% in 2023 to 60% in 2027 (See Chart 3). This could drive a new product refresh cycle with pricing advantages and contribute to the industry's recovery.

Chart 3: Penetration rate of AIPC over time (Estimates)

At the largest global tech exhibition held in January, CES 2024, Lenovo introduced its first AIPC, bringing this technology to its ThinkBook, ThinkPad, Yoga, Legion, and ThinkCentre PC product lineup. They also unveiled a range of over 40 AI-driven devices and solutions, further advancing the company's "AI for All" vision. On another note, Lenovo has climbed to become the world's third-largest enterprise data storage and AI infrastructure provider in 2023. And the company expects the future AI server growth to be nearly double that of the traditional server market. Although AI-related technologies still require more time to mature, Lenovo continues to increase its investment in innovation. Over the next three years, they plan to invest an additional USD 1 billion to accelerate the deployment of related technologies and applications. It is believed that AI will serve as a catalyst for the industry in the coming years, with its rapid penetration rate potentially bringing substantial revenue growth to the company's major businesses.

There are Hopes that the Revival of PC Demand Could Drive Operational Performance

Lenovo's business is divided into three segments: Intelligent Devices (IDG), Data Infrastructure (ISG), and Solution Services (SSG). In the first three-quarters of FY24 (from Apr to Dec 2023), the company's total revenue was approximately USD 43b, representing a 13% yearly decline. Operating profit also declined by 36% to USD 1.5b, primarily due to the downward cycle in the PC market, which impacted overall performance.

Lenovo's core business is IDG segment, which accounts for a significant 74% of its total revenue. Despite some downward pressure in the overall PC market, the revenue and operating profit of this segment declined by 14% and 18% respectively in the first three quarters compared to the previous year. However, Lenovo's overall operational performance outperforms its peers (except for HP), with PC shipments growing approximately 7 percentage points higher than the market average.

The ISG segment accounts for approximately 14% of the company's revenue. This segment has transitioned from profit to loss due to a 15% year-on-year decline in revenue, primarily driven by the high base effect. Additionally, the large fixed costs associated with this segment make it challenging to reduce expenses promptly. The company also allocated more resources to develop new projects for long-term growth, putting pressure on the segment’s profitability.

On the other hand, the SSG segment, comprising about 12% of total revenue, has shown impressive performance among the three segments. Its revenue and operating profit have achieved double-digit YoY growth for ten consecutive quarters. The current operating profit margin of this segment is 20.4%, which is significantly higher than the IDG segment being at around 7.4%. With high growth and profitability, SSG becomes a key driver for the company's future profit growth.

As the global leader in the PC market, Lenovo is expected to benefit from the recovery in PC demand. Additionally, with enterprise customers pursuing digital transformation and productivity enhancement, we believe Lenovo's SSG will continue to experience higher growth, driving improvements in its segment profit margin. This diversification of business may reduce the company's reliance on the profitability structure solely based on PC production.

Lenovo's Cash Flow has Improved Significantly with a Quick Cash Turnover and a Low Cash Flow Risk

Lenovo's current liabilities primarily consist of accounts payable, accounting for nearly 80% of its current liabilities, while interest-bearing debt represents a lower proportion. Therefore, we can assess the company's ability to manage operating liabilities by analyzing its cash conversion cycle (the average time it takes for a company to pay suppliers and receive cash from customers during the production and sales process).

The company's cash conversion cycle decreased from 10 days at the end of FY22 (Mar 2022) to 1 day in the third quarter of FY24 (Dec 2023), indicating its high level of cash flow management efficiency (See Chart 4). The inventory turnover days (the average time it takes for the company to sell inventory) also decreased by 8 days to 43 days, reflecting a quicker inventory sales pace and significant improvement in customer demand.

Chart 4: Lenovo's cash conversion cycle and days of inventory outstanding

According to Table 1, as of the end of 2023, Lenovo's net gearing ratio was only 3%, and its net debt/EBITDA was close to zero, indicating a very favorable leverage level. Additionally, although the interest coverage ratio has slightly declined, it still stands at a high of 6.1 times, reflecting the company's strong ability to meet interest payments. Considering the company's reasonable business performance, low leverage level, and strong cash position, we believe that the overall default risk for Lenovo is low.

Table 1: Lenovo’s Credit Metrics

Bond Investment

Currently, Lenovo has an issuer credit rating of BBB- / BBB (S&P/ Fitch), which falls within the investment-grade category. Given the company's favorable leverage level, substantial cash reserves for debt repayment, and a stable business model, we believe even for longer-term bonds, the credit risk remains relatively low.

Considering that the spread between longer-term bonds and shorter-term bonds is not significant, we find the 2025 bond relatively attractive. It has a current yield to maturity of approximately 5.4%, making it attractive to investors (See Table 2).

Table 2: Lenovo Group’s Bond Information

Compared to similar-sized and rated peers (See Table 3), Lenovo's 2025 bonds are noticeably more attractive. While the default risks among the three companies are rather similar, Lenovo’s bond offers higher returns which investors can consider.

Table 3: Comparison of Lenovo's Bonds

Corporate Risk

In terms of operations, the personal computer industry is highly competitive, and Lenovo needs to compete with new entrants and existing rivals in terms of products and pricing to maintain its industry-leading position. Additionally, the infrastructure solutions business is currently in a loss-making state, and the company needs to invest a significant amount of capital expenditure to develop equipment. This could potentially erode the company's current cash reserves and lead to an increase in the net debt ratio.

Lenovo derives over 70% of its sales from the IDG segment, with minimal revenue contribution from other segments. Due to the reliance on a single source of income, the company may face cash flow constraints and short-term liquidity pressures if there are issues in the sales business, leading to certain financial pressures.

Furthermore, a deterioration in economic conditions and fluctuations in the international political and trade environment can lead to consumer spending delays or reductions. As Lenovo may be classified as a Chinese technology company, any export bans imposed on hardware components by US semiconductor companies could potentially disrupt the supply chain operations, creating greater uncertainty in business operations.

Conclusion

After benefiting from a wave of pandemic-related gains, the world's largest computer equipment vendor, Lenovo Group’s performance was dragged down by a downward cycle in the personal computer market. The company's Solution Services segment recorded record-high operating profits, which will be a key driver for the company's future profit growth.

The company has a low debt ratio, good leverage position, and strong liquidity, coupled with a stable business model, we believe its default risk is relatively low.

The yield to maturity of its 2025 bonds issued is approximately 5.4%, higher than its peers and is attractive for investors.

Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.