Lenovo Q3 earnings look good, but not below the surface

Two years after the acquisition, the IBM Personal Computer Division is still dragging down the Lenovo group, say analysts.
ChinaÆs leading multinational, Lenovo Group, saw profits jump 23% for the three months ending December 2006. Net income rose to $57.7 million, from $47 million a year earlier. Sales rose to $4 billion from $3.98 billion.

However, some analysts say the results were skewed by an unusually low tax rate and the decision to reduce the amount of funds laid aside for repairs made under warranty.

ôThe tax they paid in the third quarter was only 9.5% percent. The company will have to pay the average 20-25% effective annual tax rate next quarter,ö says one analyst, who estimates that this equates to HK$50 million ($6.4 million) in payments for the next quarter.

ôThe profits basically havenÆt grown on a pre-tax basis, itÆs just the tax rate is strangely low,ö he adds.

In addition, plans to spend HK$70 million on restructuring were scaled back to spending only HK$18 million. This also boosted the bottom line.

Gross margins are also higher. But that is not because of a higher average selling price (ASP), rather that the company has reduced its warranty and repair provisions, says one analyst.

Concerns about cost were also raised. ôLenovo should have saved around $100 million from letting off 1,000 staff last year. But we canÆt see any sign of that in the resultsö says the analyst. ôI see operating costs going down next quarter because of seasonal factors, but not because of synergies,ö he adds.

Analysts are concerned that if revenues slow down while operating costs stay high, earnings will eventually suffer. Operating margins in LenovoÆs key market, China, also slipped on the back of fierce competition, especially from foreign entrants such as Dell.

The fact that sales were almost flat was reflected in slack figures for market share. ôYouÆd expect Lenovo to do well in overall global market share because itÆs active in emerging markets like China and India. But they are not,ö comments one analyst.

LenovoÆs global market share in Q3 was 7.3%, unchanged from a year earlier, and down from 7.5% in the previous quarter, according to IDC. PC shipments to the Americas fell 4%, and sales fell to $1 billion, from $1.2 billion YoY.

Analysts feel LenovoÆs problems stem from its acquisition of IBM Personal Computer Division in April 2005 for $1.75 billion. The PCDÆs operations essentially span the rest of the globe outside China.

The figures are revealing: 65% of revenue comes from the former PCD operations, but 80% of profits come out of China. This is clearly a huge mismatch, say analysts.

Lenovo is struggling frantically to switch from the traditional, but very sluggish, market to large enterprises (the so-called ærelationship' model) to the ætransactionalÆ model in the former PCD territories. This involves selling to small businesses and, eventually, consumers.

It also means cutting costs, so that top line cash makes it down to the bottom line. ôThe problem is that we canÆt gain economies of scale, and thus cut costs, until we increase our share of the transactional market,ö chief executive officer, Bill Amelio, told reporters at a press conference.

IBM is trying to get around these problems by leveraging the Thinkpad brand it acquired from IBM in perpetuity (unlike the IBM logo, which it can only retain for five years), and by setting up a dedicated Lenovo sales force, says Amelio.

Ultimately, the question for Lenovo is whether it has bitten off more than it can chew in acquiring the PCD.

Although thereÆs no reason to think that the PCD canÆt ultimately be reformed, the problem is the difference in size between the PCD and the rest of Lenovo, say observers. When Lenovo acquired PCD it had revenues of $3 billion, compared to $10 billion for the PCD.

ôItÆs been two years since the acquisition, and the company is basically at the same place as last year earnings-wise, once you take tax treatment and other things into account. So the question is: where do you go from here?ö says one observer.
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