Citi cuts Lenovo earnings outlook on higher costs, but other analysts remain neutral

Citi analysts cut their estimates of Lenovo's earnings after the world's largest maker of personal computers reported a return to profitability for the year ended March 31.

Lenovo saw full-year net income rise by $660 million on-year to $535 million on a 4.2 percent annual decline in revenue. In its outlook, the company said rising prices of components due to supply constraints would continue to present short-term challenges.

But in a note to clients, Citi analysts revised down their fiscal 2018 earnings per share estimates for Lenovo by 20 percent, from $4.33 to $3.46. Fiscal 2019 estimate was lowered by 24 percent, from $7.56 to $5.73 a share.

PCs not a sunset industry: Lenovo CFO
PCs not a sunset industry: Lenovo CFO

The analysts said the downward revision was driven by rising components costs that could see Lenovo's PC and mobile businesses face margin pressures. Citi expects modest seasonal price corrections with upside for DRAM (memory) in fourth quarter of calendar year 2017, while panels could see modest declines during the third quarter.

"Overall, we believe the margin pressure from component costs remains high," the analysts wrote. "Lenovo management believes (it) takes 1-2 quarters to adjust for the components costs, versus our view that it could be a mid-term issue."

Lenovo's PC business, which comprises a bulk of its revenue, saw unit shipments decline 1 percent in the first quarter of 2017, smaller than the overall global market that saw a 2.4 percent annual decline, according to Gartner. But analysts mostly agree that the market has stabilized in recent quarters, even though users are spending more and more time on their smartphones.

The "install base of PCs, first of all, is not growing, maybe even declining a little bit," Gokul Hariharan, Asia tech analyst and head of Taiwan equity research at JPMorgan, told CNBC. "But the decline is starting to kind of become a much slower decline than it used to be."

Hariharan said JPMorgan's view is that the days of double-digit declines in the PC market are probably done. Instead, the market has seen plenty of consolidation, where smaller brands have either exited or merged with more well-established companies. That has improved the profitability of existing players, including Lenovo, due to reduced price competition, he added.

For the full-year, Lenovo's PC and smart devices business saw a 2.3 percent annual decline in sales but still brought in about $30 billion of the overall $43 billion in revenues.

Personal computers are "a very strong, cash-cow business (for Lenovo)," said Hariharan. "But mobile and server — the two acquisitions that they did — have not turned out as they hoped it would ... both are actually losing money."

Previously, Lenovo bought Motorola's phone business from Google and purchased IBM's x86 server business.

The mobile business saw overall sales decline by 5.4 percent for the year to March 31. Lenovo will likely continue to face aggressive competition from other Chinese smartphone makers such as Huawei, OPPO and vivo — all three are currently among the top five vendors by shipments, behind leaders Samsung and Apple.

Meanwhile, the data center business —that includes servers, storage, software and services — is still undergoing transformation. It saw full year revenue decline 10.6 percent on total sales of $4.1 billion.

Wong Wai Ming, chief financial officer, of Lenovo, Yang Yuanqing, chairman and chief executive
Anthony Kwan | Bloomberg | Getty Images

Nomura analysts Patrick Chen and Lillian Lou wrote in a note that Lenovo is not competing aggressively on the hyper-scale data center hardware; but it is developing hardware capability in this area with new executive hires.

"As Lenovo does not have legacy router/storage businesses, we believe this positions it better to grab business opportunities in the software defined market, where it can focus on its hardware capability," the Nomura analysts wrote.

But JPMorgan's Hariharan pointed out that if the mobile and data center businesses continue to lose money, it could put pressure on the PC business — Lenovo might not be able to expand their PC market share as aggressively as they, otherwise, might have if the other businesses were not losing money.

"(If) you want to protect profitability, you might be a little more conservative (in the PC business)."

In a recent interview with CNBC, Lenovo's chief financial officer said the company is expecting profitability in its mobile and server businesses in the "near future."

Both Nomura and JPMorgan have a Neutral rating on Lenovo, while Citi maintained its Sell rating. JPMorgan's target price on the stock by Sept. 30, 2017 is HK$4.20; Nomura's target price is HK$6, while Citi revised its target price from HK$3.20 to $2.60.

On Friday morning at 11.18 a.m. HK/SIN, Lenovo shares listed in Hong Kong traded down 3.17 percent at HK$4.89.

— CNBC's Arjun Kharpal contributed to this report.