ACEYY - Lenovo Still Undervalued With A PC And Server Rebound Ahead As Well As AI Leverage

2023-10-13 13:23:51 ET

Summary

• PC and server markets have faced challenges in 2023, but channel inventories are finally where they need to be and 2024 should see a return to growth.
• An over-aged installed PC base in markets were Lenovo has even stronger share could be an underappreciated driver in 2024+.
• Lenovo is showing that it's serious about wanting to leverage opportunities in AI; investing $1B into R&D and revamping its product portfolio to build its GPU server business.
• Lenovo shares look undervalued below the high-$20's.

The PC and server markets have continued to be challenging throughout 2023. A combination of weaker demand and companies being too slow to clear out inventories has dragged out the recovery in PCs, while servers have suffered from more conservative enterprise budgets, hyperscale digestion, and higher component prices. Even so, it looks like channel inventories are finally where they need to be and 2024 is looking like a growth year.

I've said many times in the past that stocks often move in anticipation of fundamental market shifts, and so it has been with Lenovo (LNVGF) (LNVGY). These shares have risen close to 25% since my last update , not matching the strength of Dell (DELL), Acer (ACEYY), or ASUSTeK (ASUUY) over that time, but still outperforming HP (HPQ), Hewlett Packard Enterprise (HPE), and Apple (AAPL) (to the extent that Apple's a good comp).

I still believe there is upside to these shares. An over-aged installed base of PCs in markets where Lenovo has above-average share (China and Japan, particularly) should support growth on top of an overall PC recovery in 2024 and servers too should rebound. I also believe there's an underrated AI opportunity here, though it's still very much a "show me" story. Between discounted cash flow and multiples-based approaches, I believe Lenovo still offers a 20-25% upside over the next year or so.

With The Decks Clear, PCs And Servers Should Grow Again

One of the concerns I had in my February update on Lenovo was that the company was not moving fast enough to reduce channel inventories in a still-weak PC environment. That has since proven to be a legitimate concern, and the last two quarters have been quite weak for the PC-driven Intelligent Devices Group (or IDG), with revenue down 28% and 33%, as the company has aggressively cleared out inventory.

While overall company inventory is still elevated relative to pre-pandemic levels, PC channel inventory is back to normal, and it looks as though the market has bottomed. Lenovo saw 13% sequential growth in the third quarter (as per IDC), and higher-value segments like gaming seem to be coming back well. Looking into 2024, I think overall PC volume can grow around 5% to 7%, and I think Lenovo could take some share on top of that. I'd also note that the average age of the installed base of PCs is above average in the Chinese, Japanese, and Latin American markets - all of which are markets where Lenovo has leading share, with the first two being markets where Lenovo's share exceeds its global average (39% and 36%, respectively, versus 23% to 25%).

Server demand, too, should rebound in the coming year after a mid-teens decline in 2023. Enterprises may still be cautious on spending given an uncertain economic outlook and the upcoming election, but I think there will be some "mandatory" refresh spending, as well as a resumption in hyperscale capex. I'm expecting around mid-single-digit growth at this point, though I'm skeptical that Lenovo will be a big share-gainer. I do see other opportunities in areas where Lenovo has been strong more recently, including software, high-performance computing, edge computing, and storage (storage revenue was up 120% in FQ1'24).

Can Lenovo Execute On Opportunities In AI?

Artificial intelligence (or AI) is understandably the hot topic with enterprise IT hardware vendors, and one of the challenges now is sorting out which companies have real opportunities and which are just trying to take advantage of the buzz to go along for the ride.

On one hand, Lenovo has been talking about positioning itself for AI for years now, and management does claim that about 20% of its server demand is "AI-related". On the other hand, GPU servers are less than 5% of the server revenue base.

Management is moving aggressively to shift this. In addition to revamping the product portfolio, the company is investing $1B into AI over the next three years. In the short term, there are still some worthwhile opportunities that could be worth over $1B in incremental revenue. The company has a near-term opportunity with servers using Nvidia (NVDA) L40S GPUs - importantly, these chips don't require capacity-constrained CoWoS packaging - as well as its proprietary Lenovo Neptune liquid cooling technology.

There are also opportunities on the software and service side, and this is another area where Lenovo has been making meaningful investments. Given the complexities of AI and machine learning, I believe Lenovo has a real opportunity through its Managed Services offerings and Project & Solution Services to help smaller businesses leverage AI in ways appropriate to their needs and budgets.

The Outlook

Of course, nothing is ever that simple with Lenovo. For starters, the PC and server recoveries that I expect in 2024 could disappoint, and counting on a meaningful refresh cycle in China could be too ambitious given economic pressures there. Moreover, there's an ongoing issue of the perception that Lenovo is just a proxy for the PC market (and one that wastes capital on non-PC businesses); while I can't say that the company's diversification and capital allocation strategies have been good, I do think seeing it only as a proxy for PCs is shortsighted.

Given how Lenovo's fiscal calendar works, I do expect another down year in revenue for Lenovo in FY'24, followed by a double-digit rebound in FY'25 as the PC and server recoveries strengthen in the second half of calendar 2024. Relative to past expectations, then, my FY'24 revenue number is about 7% lower while my FY'25 number is 2% higher and my FY'26 number is 8% higher. Long term, I still expect core revenue around 3%, with possible upside from services and AI.

On the margin side, Lenovo has continued to impress on gross margins and operating expense efficiency. Higher R&D spending will offset some of that in the coming years. I'm below-Street for operating margin over the next three years (3% to 3.5% versus 3.5% to 4.5%), but I do still expect long-term FCF margins in the "mid-2%'s, supporting mid-single-digit FCF growth.

Between discounted cash flow, margin/return-driven EV/EBITDA (6x multiple), and ROE-driven P/BV (3.1x), I get a fair value range for Lenovo's ADRs of $27.25 to $29.

The Bottom Line

Lenovo has a lot to prove when it comes to its ability to thrive outside of PCs and I can understand why some analysts and investors will view the company's investments into AI as just more squandered capital. I do believe the company is on better footing than that viewpoint acknowledges, though, and as PCs and servers recover, and as the company executes in areas like AI, software, and services, I do expect an ongoing re-rating.

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