Lenovo Group Ltd: Taking Short-Term Pain For Long-Term Gain

Chinese PC, smartphone, and tablet manufacturer Lenovo (NASDAQOTH: LNVGY  ) has a knack for surprising analysts and investors that goes back a while. Lenovo defied skeptics who thought its acquisition of the IBM (NYSE: IBM  ) PC business was a losing move, leveraging that deal to build the world's largest PC business and continuing to grow its PC business at a time when the market is shrinking.

Now Lenovo is doubling down in a big way. The company's acquisition of IBM's server business was well-telegraphed and well-liked, but then the company shocked the market with the nearly $3 billion acquisition of Motorola Mobility from Google (NASDAQ: GOOGL  ) . The latter has proven quite controversial, with some sell-side analysts speculating that Lenovo will never turn Motorola around and the shares down around a quarter since the announcement.

I believe that the near-term skepticism ignores the substantial long-term opportunities at Lenovo and some significant undervaluation in these shares.

Sealing the deal in servers
In a long-awaited move, Lenovo announced the acquisition of IBM's x86 server business on January 24. The $2.3 billion deal price was even lower than I'd expected when I previewed the deal here, and this looks like a very solid deal for Lenovo. Even with IBM's recent history of under-investment in this business and share loss to Hewlett-Packard (NYSE: HPQ  ) and Dell, it remains a more profitable business than Lenovo's existing operations and that is before Lenovo takes advantage of manufacturing, sourcing, and logistical synergies.

It also appears to be a growth opportunity for Lenovo. Chinese businesses and officials have paid keen attention to the revelations of NSA spying and its possible ties to computer equipment, including Hewlett-Packard and Dell servers.  With Hewlett-Packard and Dell having about 50% share in the Chinese server market, that could be a huge potential competitive take-away opportunity for Lenovo, to say nothing of Lenovo's stronger marketing presence in emerging markets where IBM has under-invested.

For IBM, this deal monetizes an asset to which the company was really no longer committed. For Hewlett-Packard (and Dell), this is not a positive development. Not only does this sale create a Chinese "national champion" to threaten their business in China, it puts a credible business in the hands of a company that will be highly motivated to invest it and grow it.

A surprising bid for scale in smartphones
As expected as the IBM server deal was, the deal announced 11 days later for Google's Motorola Mobility was just as surprising. Lenovo will be buying the Motorola business for $660 million in cash, $750 million in stock, and $1.5 billion in a zero-interest promissory note. After this deal, Google will be a 5% shareholder in Lenovo and Lenovo will have about 8% to 9% share in the global smartphone business.

Lenovo is already a strong and growing player in China's smartphone market, but the company has been slow to enter the U.S. market. This deal will substantially accelerate that process. With Motorola, Lenovo can use a dual-brand strategy with Motorola positioned as a premium brand and Lenovo positioned as a value brand. Motorola will also bring preexisting relationships with numerous carriers (around 40), a significantly improved R&D effort, and a substantial IP estate (both owned by Lenovo and licensed from Google).

It is true that Motorola is a loss-making enterprise, with $1.1 billion in pre-tax losses in 2013. It is also true that Apple and Samsung effectively dominate the North American market for smartphones. I am bullish on Lenovo's opportunities to change both of those situations. Lenovo should be able to carve out a substantial portion of Motorola's operating costs as they will not need redundant "back office" operations, and Lenovo will likewise be targeting unit/market share growth far more than Google did – Google's interest in Motorola was largely about patents and establishing Android, not selling Motorola phones. Lenovo will also be able to leverage a substantial global sourcing effort that Google does not have.

This deal could also benefit Google down the line. Samsung is clearly a strong Android partner for Google, but it is almost always for a vendor/developer to have two strong customers rather than one dominant customer. In the meantime, Google's ownership stake in Lenovo should incentive the company to work closely with the company on a seamless transition and as an Android partner.

Lenovo does it again
Lenovo isn't a flawless company, but they do have a history of outperforming expectations, as seen in the company's recent quarterly report. Revenue rose 15% in the fiscal third quarter, beating expectations as smartphone units grew almost 50% and the company saw PC unit growth of almost 7%. With that growth, Lenovo increased its lead on Hewlett-Packard in the global PC market to almost two full points (18.6% versus 16.8%). Lenovo also reported very strong growth in tablets, but at around 4% share the company is still some distance from challenging Apple or Samsung.

It wasn't just a top-line beat. Lenovo did see some slight shrinkage in gross margin due to PC supply issues, but the smartphone and tablet business are getting more profitable more quickly than expected and Lenovo's gross margin came in a half-point higher than expected. With that, and ongoing operating efficiency, Lenovo reported 38% operating income growth and an 8% higher profit than expected.

The bottom line
Expect Lenovo to bring Motorola back to profitability relatively quickly, but gaining market share against Apple and Samsung (particularly in North America) is going to be a long-term project. Given the company's past success in PCs, though, I would bet against them at your own risk. With the acquisition of the IBM server business and Google's Motorola phone business, I see Lenovo growing revenue at a long-term rate of 9%, with free cash flow growing at a similar rate.

On a discounted cash flow basis, I believe Lenovo is worth more than $28 today, and I consider it a significantly undervalued, and proven, operator in the consumer technology space. The market has clearly freaked out in the wake of the Google deal, but those freak-outs can be profitable opportunities for long-term investors.

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