Lenovo Earnings: Robust Server Sales Do Not Translate to Improving Profitability; Fair Value Cut 4%

We trim our fair value estimate for Lenovo to HKD 13.50 per share from HKD 14.00, based on the mixed June-quarter results. On the positive side, June-quarter revenue of USD 15.4 billion was up 19.7% year on year. This was above our forecast of USD 14.6 billion, on robust PC and server sales, supporting our view that Lenovo is one of the beneficiaries of the computing demand. On the other hand, the firm's operating margin declined to 3.2% from 3.5% in the previous quarter, which makes us concerned that the robust revenue growth is not translating into sufficient profit growth. In particular, although server revenue rose about 25% sequentially, profitability did not improve substantially when we exclude the one-time charge recorded in the March quarter, which we believe is due to the rising research and development costs to accommodate the robust server demand and the low-margin nature of the business. As a result, we raise our revenue forecasts for this fiscal year and next to USD 65 billion and USD 73 billion, from USD 61.5 billion and USD 68.5 billion; but lower our operating margin assumptions to 3.6% and 4.1% from 3.9% and 4.5%, respectively. Despite lowering our earnings forecasts, we remain optimistic about Lenovo’s medium-term growth, driven by increasing PC replacement demand, and believe shares are undervalued.