Lenovo Delivering On Its Promises And Outperforming As A Result

My bullishness on Lenovo (OTCPK:LNVGY) hasn’t been the most popular of my calls over the last year, but the company has made real progress delivering on its strategic goals and the shares are up more than 70% over the past year – well above the likes of HP (HPQ), Apple (AAPL), Acer, and Dell (DELL) – and have likewise outperformed strongly since my last update even before the big post-earnings run.

With the progress Lenovo’s made, I feel more comfortable easing up on some of the conservatism I’ve used in my modeling. I don’t think the shares are hugely undervalued, but there is still plenty of skepticism out there and the company has meaningful growth opportunities in its server business that augment a healthy core PC business.

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Lenovo Delivering On Its Promises And Outperforming As A Result

Lenovo Now Getting A Fairer Assessment From Investors

Two out of three isn’t bad. Lenovo (OTCPK:LNVGY) appears to be having some ongoing success in rejuvenating its PC business, while its server/data center business continues to grow on the back of its SDI and hyperscale efforts. Mobile is still a challenge, but the company has seen some shipment growth improvement in North America and has had some success with stripping costs out of this business.

Lenovo’s improving performance hasn’t gone unnoticed, and even with a sharp dive connected to worries about Chinese-government sponsored “hacking”, Lenovo has outperformed many of its consumer tech peers like Apple (AAPL) and HP (HPQ) since my last update on the company. While expectations are still relatively low for Lenovo, I don’t see the valuation as so unreasonable anymore, and I believe the next leg in the company’s performance will have to be driven by better margin performance in the non-PC operations.

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Lenovo Now Getting A Fairer Assessment From Investors

Lenovo Making Progress, But It's Slow

Slow progress, sometimes frustratingly slow, continues to be the name of the game for Lenovo (OTCPK:LNVGY). Although there were signs of progress in the company’s fiscal third quarter (December) results, the ongoing operating challenges in the mobile business remain significant and there are no guarantees that the progress gained in the Data Center business can be held.

It hasn’t been very long since my last update on Lenovo, but since that time the shares have drifted about 5% lower, underperforming the Nasdaq and HP (HPQ) and basically matching Apple (AAPL) over that brief window. Stretch that window back a year or two, though, and the underperformance becomes much more apparent. That said, I don’t believe Lenovo is done for, and I believe expectations have been worn down to a point where Lenovo should be able to outperform in the coming years.

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Lenovo Making Progress, But It's Slow

A Drawn-Out Reset Of Expectations Should Lead To Better Days For Lenovo Shares

Lenovo's (OTCPK:LNVGY) bold and controversial decisions to try to work its PC magic in the mobile handset and server markets has thus far proved the doubters right. Margins have eroded since the acquisition of IBM's (IBM) x86 server business and Alphabet's (NASDAQ:GOOG) (NASDAQ:GOOGL) Motorola business, and the share price has fallen by two-thirds from its mid-2015 high as investors have grown weary of the delays in transforming the acquired businesses into profitable contributors and grown more concerned about the long-term health of the PC business.

There are still valid reasons to worry that Lenovo shares could be a value trap, but expectations have been beaten down to a low bar. Lenovo's strategy to target higher-performance, higher-value markets in mobile and servers is a break with the company's past, but a logical one. What's more, management has not had to surrender much market share in PCs in its effort to support margins.

If Lenovo can grow revenue at a long-term rate between 2% and 3% and pull its adjusted free cash flow margins back up into the 2%-3% range, a fair value in the range of $15 to $17 still makes sense, even with a double-digit discount rate. The key question, though, remains whether or not the company can turn its mobile and server businesses into positive contributors (and/or jettison them) and restore investor confidence in Lenovo's business model and strategy.

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A Drawn-Out Reset Of Expectations Should Lead To Better Days For Lenovo Shares

Seeking Alpha: Lenovo Looking To Have The Last Seat When The Music Stops

It's easy to dismiss Lenovo (OTCPK:LNVGY) right now. What sane management team would want to be in the PC business when shipments are declining at a double-digit rate? What sane management company would want to battle high-end smartphone champion Apple (NASDAQ:AAPL) and low-end dynamo Xaomi with the rusty blade that is Motorola at their side? Why would anybody think there's money to be made in a server business that IBM (NYSE:IBM) didn't want?

What I think many of the superficial analyses of Lenovo miss is that this is a company with a proven ability to squeeze blood from a stone and relentlessly drive costs lower. While PCs are likely never going to be a growth market again, I do think there's still an opportunity for Lenovo to gain share and take what growth is there. Likewise, I don't think Lenovo ever unseats Apple in smartphones, but I believe Lenovo's cost structure can allow it to be one of the last companies standing after the industry shakes out the weaker players. Finally, I think there's meaningful server growth opportunity in China and other emerging markets, and here too I believe Lenovo has an opportunity to benefit from stripping costs out of the IBM assets and running the business more cost-effectively.

I've decided to take a more negative view of Lenovo's revenue growth prospects, as the decline in PC shipments has been exceeding my expectations from a year ago and the smartphone market too has cooled more quickly than I expected. Nevertheless, even with a lower revenue growth rate, the opportunity to add around a point and a half to operating margin over time and a similar amount to FCF margin supports a fair value above $28.

Lenovo has to achieve its cost-reduction goals for the Motorola business on schedule to rebuild investor/analyst trust, but I believe Lenovo has seen the bottom in mobile and servers and will surprise with what it does over the next three to five years. More importantly, I think Lenovo has a cost structure and a cost philosophy that makes it a long-term survivor - as virtually every market eventually becomes a commodity market over time, cost leadership is ultimately what distinguishes the survivors and I believe Lenovo has the corporate DNA to be the last (or at least one of the last) players standing in PCs, x86 servers, and phones.

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Lenovo Looking To Have The Last Seat When The Music Stops