Dissecting Research: Lenovo (992 HK)

By Derek On January 9, 2012 Under Post

I am going to continue the series on how to dissect and make sense out of equity research reports with another tech stock. Asian tech stocks are like manufacturers and are fairly easy to understand. Of course, the environment changes much more quickly for a tech company than for a company that makes clothes pins, for example. But the variables are the same. Having said that, Lenovo (992 HK), the world’s second largest computer seller and our next victim, is becoming more of a retailer than a tech stock. For those who don’t have to live and breathe Chinese equities (I salute you), you may remember Lenovo was the Chinese computer company that purchased IBM’s PC division which was branded as the “ThinkPad.” Lenovo does have its own production facilities (25% of total) but most of their PCs and notebooks are outsourced to the same Taiwanese factories in China that fart out product for Dell, Acer, etc. In fact, one of Lenovo’s major outsourcing partners is Compal, the dead money story we looked at previously.

The positive update that follows on Lenovo is published because the analyst is raising her target price. Let’s look at her reasons.

First, note the title. The English is not correct and this is the fault of the editor, not the analyst. Most analysts in Asia speak and write English as their second language. It is essential that an on the ball editor picks up little errors like this – especially in the TITLE and especially on the FRONT PAGE!       

  1. Lenovo is in a “sweet spot” being exposed to the commercial PC segment in the developed world and consumer PCs in the developing world. They are lucky because they would be toast if it were the other way around.

TIP:

You can use words like “sweet spot” and “low hanging fruit” but only once in a conversation (with someone junior) and don’t linger over it like you just said something clever. These are clichés, people and you should refrain from using them too much because you’ll sound like a chump.

  1. These two segments are the fastest growing segments for PCs globally and the analyst believes that will continue. All pretty straightforward.
     
  2. The change is the analyst is raising her target price. Now, is she raising it from $6.00 to $15, or something significant? NO. She is raising it from $6.33 to $6.55, or 3.5%. Who the hell cares? Really, this is hardly worth it. But for our purposes, there are several things here to learn so we soldier onward.
     
  3. Lenovo operates on a fiscal year that ends in March. Many companies in Asia are on the March accounting year which means books close March 31st, not the calendar year when books close December 31st. This has to do with being an agricultural society. Forecast EPS growth is stellar this year and next. Lenovo must be the only PC growth stock in the world. Valuations at 10.5X PE next year are reasonable when you have forecast EPS growth of 18% but it isn’t spectacularly cheap.

TIP:

When you are in the fourth quarter of the year, calendar or accounting, you can “roll over” the estimates to the next year. This isn’t a hard and fast rule and some analysts do this as soon as they hit Q3. Given that most emerging market companies are growing, rolling the estimates forward to the next year makes the valuations look cheaper. You can use this method to enhance a bull story – but only spivs do this in Q1! 

 

  1. Margin expansion is absolutely key to sustainable profitability. Lenovo’s OP margin rose significantly as they grew and enjoyed greater “economies of scale.” More importantly, the analyst believes this will continue. This is probably the most important part of the bullish call on the stock. 
  2. A one-off tax provision that reduced tax rates in the quarter won’t be repeated. Just be aware of the fact but don’t sweat it. 
  3. With a market cap of US$6bn, this is a mid to large-cap story but is still tiny compared to Dell ($28 bn) and HP ($52 bn). Higher growth rates are the norm for smaller companies but Lenovo will reach a point where “the law of large numbers” kicks in and their growth rate will decelerate just like it does for all large tech stocks. This is one reason why tech stocks are never “buy and hold” candidates. Average daily turnover of $20 mn is also respectable. Large institutions can buy this without fear.

TIP:

Lastly, always look at the shareholding structure. IBM still owns 4.4% of the company and they have been selling. You should ask what “lockup,” if any, they may have. You don’t want to get a client into the stock and the next day IBM dumps its shares on the market in a placement, driving the price down. The other thing to watch for is large stakes held by what I call “low quality” shareholders such as investment banks or private equity funds. I don’t mean to say these are low quality firms, after all, I have friends that work in those places. However, financial groups tend to have volatile and short investment time horizons and today’s “strategic stake” is often tomorrow’s “opportunistic windfall.” If the market knows a large shareholder is keen to dispose of a stake that will put a cap on stock performance. 

Finally, for more on Lenovo from an insider’s point of view, listen to the podcast interview I did with Gary Ng, Head of IR at Lenovo in the “Conversations” part of the website.

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