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Lenovo (992.HK) – Initiation of Coverage 18 October 2012

Sun Hung Kai Financial Institutional Research 1

Initiating Coverage: Power Shift at the Top

Valuation of the company continues to be capped on negative sector sentiment. We expect a positive re-rating as the PC industry comes off cycle lows, with Lenovo positioned to benefit. Management’s strong execution has resulted in consistently improving margins and ROE. We estimate continued strong FCF generation over the next 2 fiscal years. We see a 35% upside to the stock on our price target of HK$8.55/share.

Three reasons to Buy:

The company has specific growth drivers that we believe will allow for continued success. Its strength in China and exposure in key emerging markets provides significant upside opportunities. Increased commoditization in the PC industry benefits the low cost, scale producer and Lenovo is positioned to benefit.

Management’s execution has been solid. Cost control and scale benefits are reflected in Lenovo’s consistently improving margins and ROE. Operating margins have increased 65 bps over the past two years while ROE has gained 13.7ppts to 22.5% over the same period.

Lenovo’s healthy balance sheet and strong FCF generation means it has the ability to execute a clearly defined strategy including expansion into non-PC businesses i.e. tablets and smartphones. The company has US$3.77bn in cash and we expect the firm to generate 16 U.S. cents/share of FCF over the next two years. Furthermore, since 2010, the company has paid out roughly US$340m in dividends and repurchased 226.1m shares, including 57m since June this year.

Catalysts:

Lenovo will announce Q2 results November 2nd. We note that fiscal Q2 and Q3 are Lenovo’s seasonally strongest quarters.

Completion of its Wuhan mobile phone factory in October 2013 and ramp up of production could be a catalyst for its mobile business to move from posting losses to profits.

Management has indicated that Lenovo remain active in M&A.

Valuation: We are initiating coverage of Lenovo with a Buy rating. Our

target price of HK$8.55/share is based on 14.5x our FY2014 earnings estimate of HK$0.59/share. We expect the company to grow the top line at 15% CAGR over the next two years while improving NPM by 40bps, translating into earnings growth of 29% CAGR. We expect a re-rating of the sector as the PC industry comes off cycle lows with Lenovo positioned to benefit. Our DCF yields an intrinsic value of HK$10/share.

Figure 1: Lenovo – Earnings Summary

Year end 31 March FY11 FY12 FY13E FY14E

Revenue – US$ m 21,594 29,574 34,253 39,153

Gross margin – % 10.9 11.7 11.9 12.1

EBIT margin – % 1.8 2.0 2.4 2.6

Net profit – US$ m 273 475 626 783

Net-profit growth – % 111 74 32 25

EPS – US$ cents 2.84 4.67 6.04 7.59

EPS growth – % 99.7 64.6 29.4 25.6

P/E – X 28.8 17.5 13.5 10.8

Dividend yield – % 1.20 2.18 2.59 3.25

P/B – X 4.45 3.57 3.05 2.57

Issued shares - millions 9,995 10,336 10,322 10,322

Sources: Company and Sun Hung Kai Financial

Stephen Yang, CFA

+852 3929 6154

[email protected]

Reports available at: http://www.shkresearch.com http://www.thomsonreuters.com http://www.capitaliq.com http://www.themarkets.com Bloomberg Code: <shkr>

Lenovo (992.HK) Technology Sector 18 October 2012

INS

TIT

UT

ION

AL

RE

SE

AR

CH

Target Price HK$8.55 12m Rating Buy (35% upside) Performance (%) 1m 3m 12m

Absolute 0.0 7.7 20.8

Relative to HSI (3.7) (2.4) 7.3

Lenovo – Price Chart

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

Oct 11 Jan 12 Apr 12 Jul 12 Oct 12

(HK$)

Stock price HSI perf. rebased to sh. price

Price (HK$) 6.33

52W high/low (HK$) 7.71/4.88

Mkt cap – HK$m (US$m) 65,339.9 (8,429)

Shares in issue – millions 10,322.25

Free float – % 57.10

3M avg. t/o– HK$m (US$m) 361.9 (46.7)

Major shareholder (%)

Legend Holdings 33.6

Sources: Bloomberg and Sun Hung Kai Financial

FY2012 Revenues: US$29.6bn

Desktop PCs33%

Notebook PCs57%

Mobile Devices

5%

Services & Others

5%



Valuation & Forecasts

The stock is trading at 14.3X FY2013 and 12.0X FY2014 analysts’ estimates. The FY2014 (FY2) P/E multiple is at the low end of its three-year range and a 25% discount to its average of 15.9x. The stock appears undervalued given analysts’ projections of over 20% earnings growth each of the next two years i.e. PEG firmly below 1X. Relative to the group, the stock commands a 15% premium due to its higher expected growth.

Figure 2: Lenovo – Historical FY2 P/E

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25

27

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-09

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BEst P/E (Next Ann) Avg +1sd -1sd


Figure 3: PC Sector Valuation

Market

Cap YTD P/E(X) FY2 EPS EV/EBITDA(X) Estimates (%) P/B(X)

Ticker Company Price(LC) ($USmm) %chg FY0 FY1 FY2 Growth FY0 FY1 FY2 Div Yld GPM FY0

992 HK Lenovo 6.33 8,429 22.0 16.6 14.3 12.0 19.3 5.8 5.1 4.4 2.2 11.8 3.5

HPQ US HP 14.57 28,647 -43.4 10.2 3.6 4.2 -13.8 3.0 3.1 3.4 3.5 23.1 0.9

DELL US Dell 9.90 17,168 -32.3 5.4 5.7 5.6 2.2 2.6 2.8 2.8 1.6 22.2 1.8

2353 TT Acer 28.15 2,736 -19.8 nmf 43.1 18.4 134.9 47.3 17.4 10.5 2.1 10.0 1.0

2357 TT Asus 301.00 7,768 39.7 11.4 10.8 10.1 7.5 16.1 7.9 7.0 5.3 13.8 2.0

AAPL US Apple 649.79 609,119 60.4 15.3 14.6 12.2 19.6 13.8 8.4 6.8 0.4 44.0 5.5

Average 4.4 11.8 15.4 10.4 28.3 14.8 7.4 5.8 2.5 20.8 2.4


P/E multiples for the industry have compressed since 2009, reflecting the deceleration in PC-shipment and revenue growth. The market is currently discounting continued weakness into next year’s shipments, despite a potential acceleration in PC shipments and revenues for 2013 as projected by market-research firms IDC and Gartner. Historically, the commercial/corporate PC refresh cycle is every 2-3 years for notebooks and 3-4 years for desktops, i.e. we get a surge in purchases as enterprises catch-up to newer technology and the cost of supporting older technology outweighs new purchases. If we are not already at the bottom of the demand cycle, then we are fairly close. There could be a re-rating of the sector as the industry comes off cycle lows.



Figure 4: Industry P/E and PC Revenue Growth

Industry PC Shipment

Month

Forward P/E Growth 1 Yr Out

Dec 2007 17.8X 10.7%

Dec 2008 7.8X 5.0%

Dec 2009 14.4X 13.7%

Dec 2010 11.8X 1.7%

Dec 2011 11.2X *0.9%

Oct 2012 9.9X *6.5%

Sources: Bloomberg, Sun Hung Kai Financial, *IDC forecasts

A reversal in sentiment for the sector could see Lenovo benefiting, due to its market momentum in the PC segment and positive operating leverage. Last year the company generated a 53% increase in EBIT on a 37% lift in sales, representing operating leverage of 1.43X. Leverage this past Q1 fiscal 2013 was 1.35X.

Our target price of HK$8.55/share is based on 14.5X our FY2014 earnings estimate of HK$0.59/share. For FY2014, we estimate 14.3% revenue growth on the back of continued global market share pickup; the addition of CCE Info to the firm’s P&L and increased revenue contribution from mobile as the company ramps up production at its Wuhan mobile factory. We think gross-margin compression due to competition will be limited since Lenovo is already at the lower end of the industry spectrum, while operating and net-profit margin expansion are probable as the company has shown consistent improvement in controlling operating expenses. Operating expenses to revenues have declined from 13.4% in FY2009 to 9.7% last year. We forecast a 40-bps improvement to NPM over the next two years, resulting in earnings CAGR of 29%. Our estimates are 8% above consensus in FY2014, mainly on higher expected margins.

We completed a bear and bull case alongside our base case scenario for FY2014. Under our bear case we assumed 7.5% revenue growth and no margin improvement. Our bull case assumes 25% top-line growth in FY2014 and a 65-bps improvement in NPM.

Figure 5: Target Price Scenario HK$/share

FY2014 P/E Base Bear Bull

13.0x $7.67 $5.85 $9.49

14.5x $8.56 $6.53 $10.59

16.0x $9.44 $7.20 $11.68

Sources: Sun Hung Kai Financial

Our DCF analysis yields an intrinsic value for Lenovo of HK$10/share. We assume WACC of 12%, a terminal growth rate of 3.0%, and capital expenditures roughly 0.9% of sale per year, in line with historical rates.

Figure 6: DCF Sensitivity HK$/share

Terminal Growth

WACC 2.5% 3.0% 3.5%

11% $10.72 $11.07 $11.47

12% $9.74 $10.00 $10.29

13% $8.97 $9.17 $9.38

Sources: Sun Hung Kai Financial



Investment Thesis

Lenovo’s growth drivers lost in a sea of negative sector headlines

PC sector news has been especially negative this year. To be fair, demand for traditional PC equipment worldwide has been soft over the past two years. In the first half of 2012, global shipments expanded 1.7% y/y and preliminary reports indicate shipments were down 8% in Q3. This compares with +1.7%y/y in 2011 and +13.7%y/y in 2010. According to industry experts, the rise of tablets and smartphone devices have cannibalized PC sales and extended the refresh cycle of PCs.

While the industry weakness has hurt traditional PC hardware leaders such as Dell (DELL.US) and HP (HPQ.US), Lenovo has benefited from company-specific drivers that have enabled it to gain market share and outperform the sector. Demand in China, Lenovo’s key market, remains robust, in 1H2012; growth was 14.9% yoy versus 3% for the market. Low PC-penetration rates in China, rising disposable incomes and increased adoption of internet services are supportive of future expansion in both the consumer and commercial segments.

Figure 7: PC shipments and Lenovo Market Share, January-June 2012

Region Lenovo %yoy Market %yoy Lenovo Share

China 11,746,558 14.9% 35,961,028 3.0% 33%

EMEA 4,541,475 68.4% 52,557,725 8.2% 9%

APLA 5,435,655 74.2% 50,385,040 -1.1% 11%

NA 2,784,005 16.4% 35,378,146 -5.5% 8%

Worldwide 24,507,693 33.0% 174,281,939 1.4% 14%

Sources: IDC and Sun Hung Kai Financial

Management boasts that its local market knowledge and extensive distribution network in China (15,000+ store fronts and partnerships with key distribution partners) are key advantages over its competitors. The company has a strong commercial mix in China with 55% of PC sales to businesses and a commanding 50% market share in the commercial segment. Furthermore, PC sales to large businesses, governments and educational institutions tend to be less price-sensitive and relationships are stickier when compared with consumer and SME (small medium enterprise) customers. In the first half of 2012, Lenovo captured 29% of PC sales in the consumer and SME market.

Figure 8: 1H2012 China Market Share (lhs) & Lenovo China Shipment Mix (rhs)

Lenovo32%

Acer9%HP

6%Dell9%

Asus7%

Others37%

Home45%

SME28%

Govt & Education

15%

Large Enterprise

12%


Lenovo’s expansion, both organically and through acquisitions, has provided favorable top-line growth relative to its peers. Aggressive marketing and pricing by Lenovo have also been factors. The risk is that Lenovo’s expansion will level off and growth will approach market rates. The law of large numbers tells us this is an eventuality but in the short to medium



term, Lenovo’s growth drivers appear positive. PC penetration rates in emerging countries where Lenovo has meaningful market share remain low and should be supportive of growth opportunities for the firm.

Figure 8: PC Penetration by Country

Country PC Install Base to

Population % Lenovo Market

Share (% FQ1 13)

Brazil 33.4 *8.2

Russia 30.4

30.4 4.2

11.6

India 4.2

4.2

17.1

PRC 21.5

21.5

35.2

Japan 58.4 25.4

USA 109.1 8.0

Sources: IDC, World Bank and Sun Hung Kai Financial * Includes recent acquisition of CCE Info

Additionally, the company’s expansion into smartphones and tablets although small at this point in time (i.e. less than 10% of revenues in FY12), provide options to the firm over the medium to longer term. The company reported 13.1% market share in smartphones in China, good enough to be No. 2 as of Q1 FY2013.

The stock has performed well vs. peers, but negative sector news continues to cast a shadow, more so between quarterly earnings, when there are limited positive catalysts. Not surprisingly, most of the upward price movement centers on Lenovo’s earnings announcements.

Figure 10: HP, Dell, Lenovo Share-Price Performance

50

70

90

110

130

150

Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12 Aug-12 Sep-12 Oct-12

Lenovo Dell HP Lenovo Earnings Announcement




Corporate Strategy Lifting Margins and Returns

The company has been executing on a clearly communicated strategy for the past few years. It’s Protect and Attack mantra centers on maintaining leadership in China while gaining market share and scale in emerging markets and more recently diversifying its product portfolio under its “PC+” strategy.

Figure 11: Lenovo’s Strategy

Source: The Company

In its home market, Lenovo has raised PC market share from under 27% in fiscal Q1 2009 to 35% in the latest fiscal quarter. Globally, it raised market share from 7.9% to 15%, moving into the #2 spot and could usurp the top spot before the end of its current fiscal year.

Figure 12: Lenovo – Regional PC Market Share (by shipments)

0%

5%

10%

15%

20%

25%

30%

35%

40%

China Europe, Middle East, Africa

Asia Pacific & Latin America

North America Worldwide

Q1 FY09 Q1 FY13


A four-year top-line CAGR of 16% and market-share gains have come at a price. Gross margins have fallen from 15% to 11.7% over the same period, while ROE compressed from 33.8% to 22.5%. The decline was not just from the company’s drive to be No. 1; trading short-term profitability for scale and volume market share, but also from the downturn in the economic cycle and a secular trend in an industry that has become increasingly commoditized.

More recent profitability trends are encouraging, signaling that the company’s execution is paying off. Gross margins and operating margins



have improved over the past year and operating expense is only 9.7% of revenues, much better than it was pre-financial crisis at 12.0%. The argument is that scale and product diversification are supporting the firm’s ROE improvements and these will be sustainable going forward. Improved industry demand next year could further enhance margins and ROE.

Figure 13: Lenovo Margins and ROE

FY2008 FY2009 FY2010 FY2011 FY2012 Q1 FY12 Q1 FY13

GPMs 15.0% 12.1% 10.8% 10.9% 11.7% 12.5% 12.0%

Op. Exp/Revenues 12.0% 13.4% 10.0% 9.2% 9.7% 10.4% 9.7%

OPMs 3.1% -1.3% 1.3% 1.8% 2.0% 2.1% 2.3%

ROE 33.8% -15.5% 8.9% 15.9% 22.5% 22.9% 23.5%

Sources: The Company and Sun Hung Kai Financial

In FY2012, segment profitability increased in the firm’s two largest markets, North America and China. The slide in emerging-market profitability implies that the company still has significant structural improvements to address in these markets. A return to profitability in emerging markets is dependent on achieving critical mass in sales volumes and could provide a significant lift to profitability over the next 2-3 years. Execution is the key.

Figure 14: Lenovo Regional Profitability

FY2011 FY2012

China 4.35% 4.45%

Emerging Markets -1.61% -1.97%

Mature Markets 1.74% 2.86%

Overall 2.35% 2.74%

Sources: The Company and Sun Hung Kai Financial

Forging ahead, Lenovo is undergoing its own transformation much like all players in the industry. The firm’s “PC+” strategy is banking on the convergence and interplay of consumer devices, namely tablets, PCs, smartphones and televisions, all supported by a unifying cloud service. Lenovo’s product-diversification strategy has gained traction in recent quarters; revenue contribution in fiscal Q1 from non-PC business was 14% compared with 6% in Q1 last year, partly from the 2011 acquisition of Medion, a Germany based consumer electronics brand. We believe the risk for Lenovo to diversify and expand into adjacent products and services is lessened by the firm’s strong FCF generation in China and healthy balance sheet. It can also leverage its strong brand, procurement capabilities and deep distribution channels in China when introducing new products.

Financials Look Solid

Management continues to actively look to expand through acquisitions globally. Over the past two years Lenovo has added the JV with NEC in Japan, Medion in Germany and more recently Brazilian electronics manufacturer CCE Info to its portfolio of assets. The balance sheet remains healthy and allows the firm to execute deals. At the end of Q1 fiscal 2013, the company had US$3.77bn in cash and US$190m in short term borrowings and notes.

Investors sometimes focus on the industry’s razor-thin margins and point to earnings volatility as negatives, but the company’s double-digit ROE and solid FCF generation should be highlighted.



Figure 15: Industry Margins and ROE

Lenovo Dell HP Apple Asus Acer

GPM 11.7% 22.3% 23.4% 40.5% 13.8% 8.1%

OPM 2.0% 7.1% 9.0% 31.2% 4.7% -1.3%

NPM 1.6% 5.6% 5.6% 23.9% 4.3% -1.4%

Asset Turnover 2.2 1.5 1.0 1.1 1.8 1.8

Financial Leverage 6.3 5.0 3.2 1.5 1.9 3.1

ROE 22.5% 41.9% 17.9% 41.7% 15.0% -7.8%

Sources: The Companies and Sun Hung Kai Financial

ROEs for Lenovo and its peers remain attractive. Thin net-profit margins are offset by higher levels of asset turnover and good use of financial leverage. We note that Lenovo’s gross margins are at the low end of the industry spectrum; risk of margin compression from increased competition therefore appears limited.

The company over the past three years has generated FCF (EBITDA net of taxes, less increases in working capital and capex) of 24 U.S. cents per share. Since changes in working capital have such a large impact on the firm’s FCF, we can use owner’s earnings (EBITDA less capex), popularized by Warren Buffet, as a proxy to gain a clearer picture of the firm’s ability to generate cash. Owner’s earnings were 12 cents/share over the past three years on 9 cents/share of earnings. We estimate Lenovo will generate 16 cents/share in owner’s earnings on 13.7 cents/share of net profits over the next two years.

We also like that the board has returned cash to shareholders cash via dividends and share repurchases. Since fiscal 2010, Lenovo has paid out US$340m in dividends and repurchased 226.1m shares, including 57m since June this year. Strong FCF generation and a healthy balance sheet should provide some buffer to weather any short- to medium-term weakness in core markets.



Risks

Dependency on China for profit generation. The company’s geographic

revenue appears diversified, but China still accounts for 70% of profits. A slowdown in demand at home would hurt profitability and the company’s ability to grow in other regions. Additionally, with such a large market in China, competitors are looking aggressively to deepen access. In 2010, Acer signed a cooperation agreement with Founder (600601.CH), a top 10 PC company in China, to manufacture and distribute Acer computers in the PRC. Although the success of Acer’s penetration in China has been limited to date, the size of the market will continue to attract competitors.

Dependency on Outsourcing. Roughly 70% of Lenovo’s products are

produced by Taiwanese ODMs. There are always IP and supply chain risks when outsourcing. Lenovo is looking to produce more products in-house and is targeting a 50% in-house and 50% outsourced manufacturing model in the future.

Overexpansion. The company may face investor scrutiny in its quest to be

No. 1. Its rich balance sheet and drive to gain market share may result in acquisitions that are non-accretive. Also, the risks of growing too fast too soon and inability to gain scale to reduce unit operating costs will hurt the bottom line. Profit margins in emerging markets continue to be negative. Additionally, the realization of synergies between acquired business units may be difficult across international waters.

Inability to make meaningful inroads with PC+ Strategy. The chase for

high-growth areas such as mobile phones and tablet PCs will incur significant marketing and development costs. Despite being No. 2 in domestic smartphone shipments, the company has very little market share outside of China for tablets or smartphones. Furthermore, its mobile business continues to operate at a loss.

Substitution of the PC. The rise of tablets and smartphones has

cannibalized sales of PCs. Market research firm Gartner expects tablets to reach 182m units by next year, +53% y/y, and expects total shipments to double by 2016. In mature markets, PC penetration rates are fairly high and demand is mainly from the upgrade/refresh cycle. The risk for Lenovo is that in emerging markets, where adoption rates are still low, users could forgo PC adoption and opt for tablet and smartphones to fill their technology needs.



Industry

The PC industry is highly competitive, resulting in low single-digit margins. Hardware has largely been commoditized and buyer demand is increasingly price sensitive. The industry is mature and revenues are tied closely to the business and corporate refresh cycle for computers.

Barriers to entry remain high due to scale and branding. Manufacturing costs are kept low through high volume production, procurement and efficient distribution. Furthermore, with scale, the cost of new product development can be amortized over a larger number of units. The industry is fairly concentrated, with the top 10 OEMs delivering more than 90% of PC shipments globally.

Figure 16: PC Market Share by Volume, Q2 2012

HP16%

Lenovo15%

Acer15%

ASUS11%

Dell10%

Toshiba8%

Samsung6%

Apple6%

Sony3%

Fujitsu2%

Other8%


Most PC OEMs, such as HP and Dell, focus on brand, design and marketing while outsourcing the majority of their hardware R&D and manufacturing to ODMs abroad. Taiwanese ODMs account for 90% of the world’s notebook production. The largest ODMs include Quanta (2382.TT), Compal (2324.TT), Wistron (3231.TT), Pegatron (4938.TT) and Inventec (2356.TT).

Industry innovation is shifting from hardware to the web (cloud) and software. Traditional PC companies are expanding horizontally and vertically, diversifying into tablets, smart phones and other consumer electronics while looking to provide value-added services such as cloud storage, software applications and enterprise services to tie in with hardware sales.

In response to the rising level of competition from Asian manufacturers and changes to industry profitability, U.S. companies such as Dell and HP have moved towards a vertically integrated IT model in order to remain relevant. Taken from a recent investor presentation, the following graphic describes Dell’s changing end-to-end IT strategy.



Figure 17: Dell’s Changing Strategy

Source: Dell

Asustek, Acer and Lenovo have extended their product offerings into smartphones, tablets and other consumer electronic devices, to hedge against weakness in the PC sector and capture high growth opportunities. Lenovo earlier this year announced a US$800m investment in a mobile phone factory in the city of Wuhan.

SWOT Analysis

Strengths Weaknesses

Well recognized global brand in the PC market.

Strong established distribution network and good relationships with government and large enterprises in China.

Healthy balance sheet and strong FCF. Current net cash position of US$3.56bn.

Willing to return cash to shareholders via dividends and stock re-purchases.

No. 2 globally in PC shipments. Volumes provide scale production benefits.

Consistent improvement in margins and ROE.

Reliance on PC sales (90% of FY12 revenues) means that an accelerated secular decline in the PC industry and cannibalization from substitute products such as smartphones and tablets could hurt short to medium term growth drivers.

Heavy dependence on China market for profits. China represents 40% of Lenovo’s revenues but 70% of profits.

Competitive market and short lifecycle of products results in thin margins and earnings volatility.

Opportunities Threats

Product diversification into consumer devices including tablets, smartphones and televisions could provide margin expansion.

Commercial and enterprise business growth from server, storage could provide margin expansion.

Ability to leverage brand and distribution channels to grow other businesses

Profitability could improve if emerging markets achieve scale economies.

The company currently outsources 70% of production to Taiwanese ODMs, but is looking to reduce that to 50%. A reduction in the reliance on ODMs could provide cost savings.

Domestic competition may erode home market share.

Inability to achieve scale in emerging markets, resulting in further profit losses abroad.

Risk of overpaying for market share gains both organically and through M&A.

Rising China wages and inflation can erode profitability and cost advantages over competitors.



Porter’s Five Forces

Suppliers – Lenovo’s bargaining power over suppliers is Strong. Accounts

payable average more than 40 days while account receivables are less than 30 days. The company manufactures 30% of its products in house and diversifies production through a number of Taiwanese ODMs.

Buyers – Lenovo’s bargaining power is Weak to Medium. The PC continues

to become more commoditized. Home buyers are price sensitive and have significant number of vendors and substitute products to choose from. Demand from commercial buyers is stickier; they prefer recognized brands and may require warranty and post-purchase service.

Threat of New Entrants – Barriers to entry remain high due to scale and

branding. Manufacturing costs are kept low through high volume production, procurement and efficient distribution. The top 10 OEMs deliver more than 90% of PC shipments globally.

Threat of Substitutes – Medium to high. The refresh/upgrade cycle of PCs

are being extended due to cannibalization from smartphones and tablets.

Rivalry – The PC industry is highly competitive, resulting in low single-digit

margins. The industry is mature and revenues are tied closely to the business and corporate refresh cycle for computers.

Figure 18: Competitor Snapshot

Lenovo

(992.HK)

Dell

(DELL.US)

HP

(HPQ.US)

Apple

(AAPL.US)

Asus

(2357.TT)

Acer

(2353.TT)

Fiscal Yr-End 31-Mar 31-Jan 31-Oct 30-Sep 31-Dec 31-Dec

EV 5,147 16,838 56,522 430,142 5,433 2,025

Market Cap 8,429 17,168 28,647 609,119 7,768 2,736

PC Shipments CY2011 44,016 44,280 62,321 17,821 20,619 37,094

Market Share CY2011 12.1% 12.2% 17.1% 4.9% 5.7% 10.2%

% revenues from PCs 90% 50% 28% 27% 61% 84%

Revenues 29,574 62,071 127,245 108,249 13,069 16,174

yoy % growth 37.0% 0.9% 1.0% 66.0% -10.6% -24.4%

GPM 11.7% 22.3% 23.4% 40.5% 13.8% 8.1%

OPM 2.0% 7.1% 9.0% 31.2% 4.7% -1.3%

Net Income 473 3,492 7,074 25,922 564 (225)

NPM 1.6% 5.6% 5.6% 23.9% 4.3% -1.4%

ROE 22.5% 41.9% 17.9% 41.7% 15.0% -7.8%

Net Debt (Net Cash) (3,981) (5,564) 22,591 (81,570) (1,577) (1,144)

D/E 7.8 103.8 78.5 0.0 4.0 31.1

Days Inv. 14.1 10.4 26.1 5.2 57.2 33.9

Days A/R 29.3 59.6 61.5 18.3 44.4 71.4

Days A/P 44.2 88.0 53.9 75.6 55.5 73.9

CCC (0.8) (18.0) 33.7 (52.1) 46.1 31.5

Source: The Company, Bloomberg, IDC and Sun Hung Kai Financial



Background

Lenovo is a personal technology company headquartered in Beijing with offices in 160+ cities worldwide and currently the second largest PC vendor by shipment volumes. It was formed in 1984 by chairman Liu Chuanzhi and 10 other colleagues under the predecessor name Legend Group. In 1988, the company incorporated in Hong Kong and in 1994 was listed on the Hong Kong stock exchange under ticker 992.HK. Lenovo’s largest shareholders are Legend Holdings (33.6%), the original IT investment company that formed the group and current CEO Yang Yuanqing (8.4%).

Figure 19: Ownership Structure

Ownership %

Public 57.8

Legend Holdings 33.6

Yang Yuanqing (CEO) 8.4

Other Directors 0.3

Sources: The Company

The purchase of IBM’s PC business in 2005 was the company’s most transformative corporate development in recent times. With the acquisition, Lenovo gained significant access to overseas markets and IBM’s ThinkPad line, a well-recognized commercial PC brand globally.

Revenues

In fiscal 2012, the company reported US$29.6bn in revenues. Notebook and desktop computers accounted for 90% of revenues. The Think Product Group targets mainly commercial customers and benefits from corporate PC demand. The company serves global, large-enterprise customers through relationships with value added resellers such as IBM. Small, medium businesses and consumers are served by the e-tailers, distributors and retailers. The mix differs region by region; for example, in China 51% of sales are through retailers while distributors account for 30% of sales. In EMEA retailers are only 23% of Lenovo’s customers while distributors account for over 50%. The company offers a wide range of commercial desktops and notebooks to businesses. Last year, Lenovo’s commercial business accounted for roughly 60% of the company’s shipments and was #3 in global shipments with 16.0% market share, behind Dell and HP. Launched in 2008, the Idea Product Group primarily focuses on consumer products. In 2011, Lenovo was no. 3 in market share for consumer shipments with 12% behind HP and Acer.

Figure 20: Revenues (lhs) and Profit Mix (rhs) by Region

China42%

APLA22%

EMEA21%

NA15%

China70%

APLA0%

EMEA10%

NA20%

Source: The Company and Sun Hung Kai Financial



Figure 21: Lenovo Products

Source: The Company

Cost of Sales

Lenovo manufactures ~30% of its own products and outsources the majority to Taiwanese ODMs. Its supplier base is diverse and based on filings, Compal Electronics is its largest equipment supplier. Last year, the company signed a joint venture with Compal to build a US$300m factory in Hefei, China. Lenovo also has factories in Chengdu, Japan, Brazil and Argentina. GPM in FY12 was 11.65% compared with 10.95% the year before.

Operating Expenses & Others

In fiscal 2012, selling and distribution expenses were US$1.69bn, up 63% y/y. The increase was mainly attributable to increased marketing and branding activities and employee-benefit costs. The company has 27,000 employees worldwide and employee-benefit costs in fiscal 2012 were US$1.94bn, up 35% compared with 2011. Selling and distribution expenses were 59% of total operating expenses compared with 36% the year before. Administrative expenses were up 1.5% y/y to US$730m in FY2012. R&D last year was US$453m or 1.5% of sales.

Figure 22: Operating expenses

US$m FY2011 FY2012 %chg %OpEx %Rev.

Revenues 21,594

21,594

29,574 37.0% nmf 100.0%

Selling & Distribution 1,038 1,691 62.8% 59.0% 5.7%

Admin 720 730 1.5% 25.5% 2.5%

R&D 303 453 49.4% 15.8% 1.5%

Other Exp. (79) (11) -86.1% -0.4% 0.0%

Total Operating Expense

dExpense

1,982 2,863 44.5% 100.0% 9.7%

Source: The Company and Sun Hung Kai Financial

The company operates in a significant number of countries and is subject to taxation in those jurisdictions. In China, it has been granted certain tax concessions. Weighted-average tax rate in 2012 was 31%, but effective tax rate on the P&L was 18%. The company adopts a consistent hedging policy for business transactions to reduce the risk of currency fluctuations on



transactions. It estimated that last year for every 1% weakening of the USD, net profit would increase US$1.69m mainly on gains/losses on the translation of un-hedged portions of receivables and payables.

Recent Corporate Announcements

The company has made some significant announcements this calendar year, in line with its PC+ strategy. In May, it announced a US$800m investment in a mobile-phone factory in Wuhan, expected to come online in the second half of 2013. In August, the company signed a partnership with EMC (EMC.US), a server and storage company, to deliver products into China and globally.

In September, it announced the purchase of CCE Info, a Brazilian electronics manufacturer, for roughly US$147m upfront purchase price plus US$200m in earn-outs at the end of four years, based on undisclosed market share and profitability targets. The deal is expected to be complete by the end of fiscal Q4 and would bring the company’s PC market share in the country to 8% from under 4% and provide exposure to more consumers, government and educational institutions. The announcement comes strategically ahead of Brazil’s World Cup 2014 and Olympics 2016. The upfront transaction multiple for the acquisition is 13X trailing earnings or just below 2X net asset value based on data from filings. Assuming a maximum payout after four years discounted at 12%, the deal multiple would be 24X.



Appendix: Financial Statements

US$mm Mar-11 Mar-12 Mar-13 Mar-14 US$mm Mar-11 Mar-12 Mar-13 Mar-14

P&L FY2011 FY2012 FY2013E FY2014E Balance Sheet FY2011 FY2012 FY2013E FY2014E

Revenue 21,594 29,574 34,253 39,153 PPE 209 392 423 464

COGS (19,230) (26,128) (30,161) (34,422) Intangibles 2,134 3,091 3,140 3,212

GP 2,364 3,446 4,092 4,731 Total non-current assets 2,769 4,040 4,120 4,232

Other Income 0 1 - -

Inventories 804 1,218 1,260 1,415

Selling & Distribution (1,038) (1,691) (1,901) (2,168) A/R 1,761 2,994 3,097 3,218

Administration (720) (730) (813) (927) Cash & Equivalents 2,997 4,171 4,650 5,353

R&D (303) (453) (554) (619) Total current assets 7,936 11,820 12,443 13,422

Other Expenses 79 11 (7) - Total Assets 10,706 15,861 16,563 17,654

OpEx (1,982) (2,863) (3,276) (3,714)

Operating Profit 382 584 815 1,016 A/P 2,180 4,050 4,344 4,926

ST Debt 371 190 190 190

Other Expenses (24) (2) 9 14 Total current liabilities 8,033 11,810 12,104 12,685

Profit Before Tax 358 582 824 1,031

Taxes (85) (107) (198) (247) Loans - - - -

Total non-current liabilities 838 1,603 1,603 1,603

Net Profit 273 475 626 783 Total liabilities 8,871 13,413 13,707 14,289

NP Owners 273 473 623 783

Owner's Equity 1,835 2,361 2,766 3,276

EPS (US$ cents/share) 2.8 4.7 6.0 7.6 Total Equity 1,835 2,448 2,856 3,365

EPS (HK$ cents/share) 22 36 47 59

DPS (HK$cents/share) 8 14 16 21

Mar-11 Mar-12 Mar-13 Mar-14 US$mm Mar-11 Mar-12 Mar-13 Mar-14

Ratios FY2011 FY2012 FY2013E FY2014E Cash Flow FY2011 FY2012 FY2013E FY2014E

Revenue Growth 30.0% 37.0% 15.8% 14.3% Operating 965 1,940 1,039 1,369

Op. Profit Growth 74.8% 52.8% 39.6% 24.6%

NP Growth 111.2% 74.0% 31.7% 25.1% CapEx (148) (329) (343) (392)

GPM 10.9% 11.7% 11.9% 12.1% Other 214 (508) - -

Exp/Rev 9.2% 9.7% 9.6% 9.5% Investing 66 (837) (343) (392)

OPM 1.8% 2.0% 2.4% 2.6%

NPM 1.3% 1.6% 1.8% 2.0% Financing (373) (316) (218) (274)

Net Debt (Net Cash) (2,626) (3,981) (4,459) (5,162)

D/E 20.2% 7.8% 6.7% 5.7% Net Cash 658 787 478 703

ROA 2.8% 3.6% 3.9% 4.6% FX 58 16 - -

ROE 15.9% 22.5% 24.3% 25.9% End Cash 2,954 3,758 4,236 4,939

Days Inventory 16.0 14.1 15.3 15.0

Days Receivable 26.8 29.3 33.0 30.0

Days Payables 50.3 44.2 52.5 52.0

Days Cash (7.6) (0.8) (4.3) (7.0)

Sources: Bloomberg, the Company and Sun Hung Kai Financial



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