Structural Challenges in Datacenter Keep Us UW

Transcription

1 September 10, :27 PM GMT Lenovo Structural Challenges in Datacenter Keep Us UW Stock Rating Underweight Industry View In-Line Price Target HK$3.60 Cut PT to HK$3.6 (11x average F e EPS) on lower PC margin forecasts and slower profit recovery at datacenter. On top of PC margin contraction, our first AlphaWise China CIO survey is evidence of Lenovo's weakening position in datacenter market amid cloud migration trend. WHAT'S CHANGED? Lenovo From: To: Price Target HK$4.00 HK$3.60 F2018e/F2019e/F2020e EPS -23%/-6%/-4% Stay UW: We have yet to see signs of a revival in Lenovo's overall business. We see structural challenges in the datacenter and PC businesses, and the sustainability of a smartphone turnaround remains a question mark. We expect the ongoing PC share loss, muted PC margin recovery and slow profit improvement at datacenter as negative catalysts for the stock. Datacenter business can the investment bear fruit? We view the structural cloud migration trend as a long-term negative for Lenovo given the clear share shift from traditional IT vendors to cloud service providers. According to our latest AlphaWise CIO survey undertaken in China and the US, most CIOs believe that traditional IT vendors will lose IT budget share to cloud service providers in the next three years amid the move to cloud. The survey also shows that Lenovo's leading position in GPU server for fast-growing machine learning application), see fierce competition from other players. We thus view its two-year turnaround target as challenging given the unfavorable industry trend and information security concerns in mature countries. PC business is a long-term margin target of 5.0% still achievable? In our view, achieving that target will be difficult. Recent contraction in the PC segment's profit margin is not only because of the component price increase, in our view, but also the fierce competition within the top three PC players. We are more conservative than the market on the PC business, as we believe Lenovo's PC margin will stay below its long-term target of 5.0% from F2018 onward. Mobile business is the turnaround different this time? This remains to be seen. While Lenovo showed narrower losses in F1Q18, we believe it is too early to conclude a sustainable turnaround given the high volatility, short product cycle and fierce competition in smartphones. F3Q16 result was a good example Lenovo's results improved to nearly breakeven, but the losses since escalated. MORGAN STANLEY ASIA LIMITED+ Melrose Chiu EQUITY ANALYST Melrose.Chiu@morganstanley.com MORGAN STANLEY TAIWAN LIMITED+ Sharon Shih EQUITY ANALYST Sharon.Shih@morganstanley.com Lenovo ( 0992.HK, 992 HK ) Greater China Technology Hardware / China Stock Rating Underweight Industry View In-Line Price target HK$3.60 Up/downside to price target (%) (13) Shr price, close (Sep 7, 2017) HK$ Week Range HK$ Sh out, dil, curr (mn) 11,109 Mkt cap, curr (mn) US$5,893 EV, curr (mn) US$7,911 Avg daily trading value (mn) HK$279 Fiscal Year Ending 03/17 03/18e 03/19e 03/20e ModelWare EPS (US$) Prior ModelWare EPS (US$) Consensus EPS (US$) Revenue, net (US$ mn) 43,035 44,241 43,300 42,463 EBITDA (US$ mn) 1,414 1,349 1,560 1,564 ModelWare net inc (US$ mn) P/E P/BV RNOA (%) ROE (%) EV/EBITDA Div yld (%) FCF yld ratio (%) 20.9 (5.5) Leverage (EOP) (%) Unless otherwise noted, all metrics are based on Morgan Stanley ModelWare framework = Consensus data is provided by Thomson Reuters Estimates e = Morgan Stanley Research estimates Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. += Analysts employed by non-u.s. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account. 1

2 Lenovo: Financial Summary Exhibit 1: Lenovo: Financial Summary Income Statement Cash Flow Statement US$ mn; Year end March F2017 F2018E F2019E F2020E US$ mn; Year end March F2017 F2018E F2019E F2020E Net sales 43,035 44,241 43,300 42,463 Operating CF 2, ,341 COGS (36,929) (37,959) (36,922) (36,188) Net Profits Gross profit 6,106 6,282 6,378 6,275 Depreciation Other operating income Equity losses/(income) Operating expenses (5,444) (5,683) (5,568) (5,461) Other adjustments 821 (795) (538) 41 Operating income Investing CF (1,398) (106) (106) (106) Profit/Loss of Investment Capex (118) (106) (106) (106) Finance income Change of S/T investment (112) Finance cost (232) (242) (233) (223) Other adjustments (1,579) Pre-tax income Financing CF 145 (754) (722) (772) Income tax 41 (18) (110) (109) Increase in L/T debt (186) Consolidated income Increase in S/T debt Minority interest (5) Issuance of stock Net income Cash dividends (377) (187) (132) (182) Diluted EPS (US cents) Dir.& Emp. Bonus Changes in Treasury Stocks Other adjustments 708 (567) (590) (590) FX adjustment (40) Net change in cash 828 (512) (77) 463 Balance Sheet Financial Ratios US$ mn; Year end March F2017 F2018E F2019E F2020E US$ mn; Year end March F2017 F2018E F2019E F2020E Cash 2,755 2,242 2,166 2,628 Margins Mkt securities Gross margin 14.2% 14.2% 14.7% 14.8% AR/NR 4,537 4,866 4,763 4,671 Operating margin 1.6% 1.4% 1.9% 1.9% Inventory 2,794 2,847 2,954 2,895 Pretax margin 1.1% 0.9% 1.5% 1.5% Others 4,729 4,729 4,729 4,729 Net margin 1.2% 0.9% 1.2% 1.2% Current Assets 14,868 14,739 14,666 14,977 YoY growth Long-term investments Sales -4% 3% -2% -2% Fixed assets 1,649 1,555 1,461 1,367 Operating profits NM -11% 35% 1% Other assets 2,031 2,031 2,031 2,031 Pretax profits NM -17% 54% 1% Total Assets 27,186 26,977 26,830 27,068 Net profits NM -29% 38% 2% EPS NM -29% 38% 2% S/T borrowings Others AP/NP 6,486 6,073 5,538 5,428 Net Debt/Equity 7% 18% 19% 8% Other ST liabilities 11,778 11,778 11,778 11,778 Liabilities/Equity 564% 528% 473% 438% Other liabilities 1,790 1,790 1,790 1,790 Liabilities/Assets 85% 84% 83% 81% L/T debt 2,967 2,967 2,967 2,967 ROAE 15% 9% 12% 11% Total Liabilities 23,091 22,679 22,144 22,033 ROAA 2% 1% 2% 2% AR/NR Turnover (days) Common shares 2,690 2,690 2,690 2,690 AP/NP Turnover (days) Reserves ,125 1,473 Inventory Turnover (days) Shareholders' equity 4,095 4,298 4,686 5,034 Cash conversion (days) Total Liab./SH's Equity 27,186 26,977 26,830 27,068 Source: Company data, Morgan Stanley Research (E) estimates 2

3 Risk-Reward Snapshot: Lenovo (0992.HK, HK$4.15, UW, PT HK$3.60) PC margin contraction + structural negative of cloud adoption to weigh on profit improvement HK$ Price Target NT$3.6 Base-case, residual income model HK$4.15 HK$6.40 (+54%) HK$3.60 (-13%) HK$1.60 (-61%) 0 Sep-15 Mar-16 Sep-16 Mar-17 Sep-17 Mar-18 Sep-18 Price Target (Sep-18) Historical Stock Performance Current Stock Price Source: Company data, Morgan Stanley Research WARNINGDONOTEDIT_RRS4RL~0992.HK~ Bull NT$6.4 17x avg F2018/19 bull case EPS Strong sales revival across all the product segments; mobile business turnaround; faster profit improvement at datacenter business: 1) PC sales to grow at 5% CAGR in F e. 2) Mobile business breaks even for the full year in F ) OPM for datacenter business improves to -6.0% in F2019 from % in F2017. Base NT$3.6 11x avg F2018/19 EPS Muted sales growth across all the product segments; mobile and datacenter businesses stay loss-making: 1) PC sales to decline 2% p.a in F e.. 2) Mobile business OPM stays negative at -4.0% in F ) OPM for datacenter business remains at losses of -11.5% in F2018. Bear NT$1.6 4x avg F2018/19 bear case EPS Severe sales decline across all the product segments; losses at mobile and datacenter businesses escalate: 1) PC sales to decline 10% p.a in F e. 2) Mobile business OPM stays negative at -10% in F ) OPM for datacenter business remains at losses of -15% in F2018. Investment Thesis We remain cautious on Lenovo in view of limited improvement in core business earnings. We see rising risks to its stable PC business due to keen competition from top tier PC peers. On top of that, we expect structural challenges at its mobile and datacenter businesses to weigh on the turnaround. We think Lenovo will face intensified competition in the overseas smartphone market from the Chinese smartphone brands. In addition, we expect information security concerns and the ongoing migration to cloud to impact its overseas datacenter business. Current valuation looks stretched at 13.6x average F e EPS, vs. HP at 11.5x and Asustek at 11.8x. We view the valuation premium as unjustified given Lenovo's rising earnings risk from PC weakness on top of its inferior balance sheet (net cash position for Asustek). Key Value Drivers Global PC demand growth, especially in China Global smartphone demand growth Potential Catalysts Slower than expected PC recovery Larger than expected loss in mobile and datacenter businesses Risks to Achieving Price Target Upside: 1) faster than expected smartphone and datacenter turnaround; 2) stronger PC demand recovery in China; 3) better cost saving and product mix improvement 3

4 Datacenter Business Accelerating Cloud Migration a Structural Negative AlphaWise Survey Methodology In cooperation with Morgan Stanley's AlphaWise team, we conducted telephone and online interviews with 126 CIOs in China about cloud adoption and other related topics during April to June Respondents cover various enterprise formats, including government / state-owned enterprises, larger private enterprises, SMEs, and MNCs in China. They are also diversified in terms of sectors, covering manufacturing, retail, technology, banking and quite a few other segments. Even though these respondents tend to be early adopters of cloud migration, we believe this survey is a good indication of the potential of cloud business in China as a broader market audience receives the service better. We expect Lenovo's datacenter sales to remain muted in F2019 and F2020 despite its reinvestment in the product portfolio and expansion of the sales channel in overseas markets. We expect the on-premise market to continue to shrink amid the accelerating cloud adoption, which will result in a market share shift from traditional hardware OEMs (like HP, Dell and Lenovo) to ODMs (like Quanta, Inventec and Wistron). For the China market, the ongoing public cloud adoption should propel growth in the hyperscale market (Alibaba, Baidu and Tencent, often referred to at "BAT"), which used to be the major growth driver for Lenovo post the consolidation of IBM's x86 server business in F3Q15 (C4Q14). But Lenovo has strategically reduced the business with hyperscale customers given the aggressive price competition and razor-thin margin. Therefore, we are cautious on Lenovo's datacenter business. We expect the datacenter business to stay loss-making at around US$ mn per year in the next two years. Accelerating cloud migration to weigh on traditional IT vendors According to our latest AlphaWise CIO survey in the US and China, the US CIOs expect the percentage of workloads on the public cloud will reach 22% by the end of 2017 and grow to 45% by We see a similar trend in China. China's CIOs anticipate the percentage of workloads on the public cloud will increase to 22% by the end of 2017 and expand to 29% by With the cloud migration trend, most of the CIOs in the US and China expect traditional IT vendors (like HPE, Dawning, Inspur and Lenovo) to lose share from the whole IT budget in the next three years, while the cloud service providers (like AliCloud, Huawei, Amazon, Microsoft and Google) will be the main share gainers. Morgan Stanley is acting as financial advisor to HP Inc. ("HP") in relation to the proposed 4

5 acquisition of Samsung Electronics Co., Ltd.'s printer business, as announced on September 12, The proposed transaction is subject to regulatory approval and other customary closing conditions. HP has agreed to pay fees to Morgan Stanley for its financial services. Please refer to the notes at the end of the report. Exhibit 2: Location of workload: China Location of workload: China Exhibit 3: Location of workload: US Location of workload: US End of % End of % End of % End of % Today 20% Today 17% 0% 20% 40% 60% 80% 100% Public cloud Private cloud Non-cloud 0% 20% 40% 60% 80% 100% Public cloud Private cloud Non-cloud Source: AlphaWise, Morgan Stanley Research Source: AlphaWise, Morgan Stanley Research Exhibit 4: China AlphaWise CIO survey: vendors to gain/lose incremental budget in the next 3 years Exhibit 5: US AlphaWise CIO survey: vendors to gain/lose incremental budget in the next 3 years Source: AlphaWise, Morgan Stanley Research Source: AlphaWise, Morgan Stanley Research Market share shift from traditional hardware OEMs to ODMs in the overseas datacenter hardware market Lenovo started to reinvest in its product portfolio and sales channel in November 2016, when the new leader of the Data Center Group came on board. Lenovo's strategy is to revitalize the overseas enterprise business and expand into the hyperscale market. However, we believe the contribution from the investment will likely be partially offset 5

6 by the trend of cloud migration and information security concerns in the mature countries. For the overseas enterprise market, we see shrinking demand going forward given the continued workload migration to the cloud. According to IDC, public cloud datacenter hardware (server + storage + switch) accounted for 23% of total datacenter hardware (public + private + non-cloud) in 2016, up from 15% in We thus expect growth in the overseas enterprise market to be capped due to declining demand. On top of that, information security concerns in mature countries (like the US and in Western Europe) may prevent mature countries from purchasing hardware products from Chinese vendors, like Lenovo. For the overseas hyperscale market, we see limited opportunities for Lenovo to penetrate here, as it lacks a competitive advantage compared to Taiwanese ODMs in terms of cost, flexibility, design capability and long-standing relationships with major hyperscale datacenter customers (like Google, Facebook and Amazon). According to IDC, ODM direct's market share in global server shipments rose to 16% in 2016, up from 13% in 2013, while the combined server shipment share at Dell and HP fell to 41% in 2016 from 51% in Exhibit 6: Datacenter hardware value breakdown by market (public cloud, private cloud and non-cloud) 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Cloud IT Infrastructure Value Mix 76% 15% Source: IDC, Morgan Stanley Research 63% 23% Public cloud Private cloud Non-cloud Exhibit 7: Global server shipment breakdown by vendor Server Shipment Breakdown by Vendor 100% 90% 80% 70% 13% 60% 50% 16% 40% 30% 20% 10% 0% HP Dell IBM ODM direct Others Source: IDC, Morgan Stanley Research Diminishing leading position in the GPU server market The GPU server is used in the application of AI (artificial intelligence) and machine learning, which we expect to see ample growth potential together with the take-off of AI application in the future. According to our latest AlphaWise CIO survey in China, Lenovo is currently the leader in the GPU server market (15% of CIOs use it today). However, we expect Lenovo will face intensified competition from other vendors as the survey indicates that the increasing interest in switching to other vendors, like Salesforce.com, IBM Watson, Inspur, HPE and Microsoft, from China CIOs. 6

7 Exhibit 8: China AlphaWise CIO survey: Lenovo is the leader in GPU servers but faces declining interest from China's CIOs Salesforce.com Machine Learning with Apex Lenovo IBM Watson Inspur Microsoft Machine Learning or Cortana HPE Haven OnDemand Sugon (Dawning) Interest in GPU Servers By Vendor Supermicro Cray Quanta 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 32% 26% 33% 35% 33% 36% 13% 9% 9% 8% Use Today Considered And Will Use Considered But Won't Use Aware But Haven t Considered Source: AlphaWise, Morgan Stanley Research 7

8 PC Business Structural Concerns on Margin Contraction Lenovo's F1Q18 PC performance echoed our cautious view that the PC margin is at risk due to keen competition from HP and Dell. We thus expect Lenovo's PC segment profit margin to stay below 5.0% from F2018e onwards, despite our expectation that the component price hike may gradually ease after couple of quarters. This could be a negative surprise to the market as the market in general believes Lenovo can sustain its PC segment profit margin at 5.0% over the long term and the weak margin performance in F2018e is mainly because of the key component price hike. Exhibit 9: Lenovo's PC shipment YoY and market share (%) Exhibit 10: Lenovo aims to maintain PC segment margin at 5.0% YoY (%) 20% 15% 10% 5% 0% mkt share (%) 21% 20% 24% 18% 12% 6% 0% margin (%) 5.4% 5.2% 5.0% 4.8% 4.6% 4.4% -5% -6% 4.2% -10% H17 PC shipment market share (%) PC shipment YoY (%) -12% 4.0% C1Q15 C2Q15 C3Q15 C4Q15 C1Q16 C2Q16 C3Q16 C4Q16 C1Q17 C2Q17 Lenovo PC segment profit margin (%) Source: IDC, Morgan Stanley Research Source: Company data Exhibit 11: Peer comparison: quarterly PC sales YoY (%) Exhibit 12: Peer comparison: quarterly PC segment profit YoY (%) YoY (%) PC Sales YoY (%) Comparison YoY (%) PC Segment Profit YoY (%) Comparison 15% 100% 10% 80% 5% 60% 0% 40% -5% 20% -10% 0% -15% -20% -20% C1Q16 C2Q16 C3Q16 C4Q16 C1Q17 C2Q17-40% C1Q16 C2Q16 C3Q16 C4Q16 C1Q17 C2Q17 Lenovo HP Dell Lenovo HP Dell Source: Company data Source: Company data 8

9 Exhibit 13: Peer comparison: PC shipment YoY growth by region in 1H17 Exhibit 14: Peer comparison: PC shipment YoY growth by segment in 1H17 Source: IDC, Morgan Stanley Research Source: IDC, Morgan Stanley Research Sensitivity analysis PC business is crucial to Lenovo as it is the only profit contributor: We conduct a sensitivity analysis on Lenovo's PC business as we think any impact on the profitability of the PC business is particularly important as PC currently is the only profit contributor to Lenovo. Our analysis shows that every 5% PC revenue shortfall would lead to ~10% total net profit shortfall; every 0.5ppt PC segment profit margin contraction will result in a 20-25% total net profit miss. Exhibit 15: Sensitivity analysis: PC sales and margin change F2019e PC segment profit margin (%) Impact on F2019e net profit forecast % change to our F2019e PC sales forecast -10% -5% 0% 5% 10% 3.5% -64% -55% -47% -39% -31% 4.0% -43% -33% -24% -14% -5% 4.5% -21% -11% 0% 11% 21% 5.0% 0% 12% 23% 35% 47% 5.5% 21% 34% 47% 60% 73% Source: Morgan Stanley Research estimates 9

10 Earnings Estimates Revision Summary We lower our F2018 pretax profit estimate by 24%, to US$409mn: The sizable pretax profit cut mainly reflects our lower PC segment profit margin assumption of 4.3% in F2018 versus our previous forecast of 4.7%. We turned more conservative on the PC segment profit margin outlook as we expect the component price hike to impact throughout the year, and we expect competition from HP and Dell to intensify. We trim our F2019 and F2020 pretax profit estimates by 6% and 5%, respectively: This mainly reflects the lower PC segment margin assumption and slower profit improvement at the datacenter business given the structural negatives of migration to cloud plus the information security concerns in mature overseas markets. We thus revise down our F2019 and F2020 pretax profit estimates to US$631mn in F2019e and US$639mn in F2020e. Exhibit 16: Lenovo: Earnings Estimates Revision Summary (US$m) New Old Diff Diff Diff % New Old % New Old % P&L Summary F2018E F2018E F2019E F2019E F2020E F2020E Net sales 44,241 44,660-1% 43,300 43,933-1% 42,463 42,868-1% COGS (37,959) (38,174) (36,922) (37,367) (36,188) (36,447) Gross profit 6,282 6,486-3% 6,378 6,566-3% 6,275 6,422-2% Operating expenses (5,683) (5,760) (5,568) (5,725) (5,461) (5,575) Operating income % % % Non-operating income (190) (190) (179) (173) (175) (176) Pre-tax income % % % Income tax (18) (35) (110) (117) (109) (117) Net income % % % EPS (HK cents) Margins Gross margin 14.2% 14.5% 14.7% 14.9% 14.8% 15.0% Operating margin 1.4% 1.6% 1.9% 1.9% 1.9% 2.0% Pretax margin 0.9% 1.2% 1.5% 1.5% 1.5% 1.6% Net margin 0.9% 1.1% 1.2% 1.3% 1.2% 1.3% Source: Morgan Stanley Research (E) estimates Exhibit 17: Lenovo: quarterly segment performance F1Q16 F2Q16 F3Q16 F4Q16 F1Q17 F2Q17 F3Q17 F4Q17 F1Q18 PCSD business group Sales (US$mn) 7,557 8,468 8,400 6,371 6,992 7,804 8,598 6,682 7,005 Segment profit (US$mn) Segment profit margin (%) 4.8% 4.6% 4.8% 4.7% 5.3% 5.2% 5.0% 4.3% 4.2% Mobile business group Sales (US$mn) 1,815 2,336 2,851 1,546 1,706 2,045 2,185 1,772 1,746 Segment profit (US$mn) (273) (219) (47) (123) (206) (156) (155) (221) (173) Segment profit margin (%) -15.0% -9.4% -1.6% -8.0% -12.1% -7.6% -7.1% -12.5% -9.9% Datacenter business group Sales (US$mn) 1,077 1,177 1, ,086 1,083 1, Segment profit (US$mn) (40) (33) (13) (16) (64) (141) (124) (141) (144) Segment profit margin (%) -3.7% -2.8% -1.0% -1.6% -5.9% -13.0% -11.8% -16.6% -14.8% Exhibit 18: Lenovo: quarterly profit breakdown by segment US$mn F1Q16 F2Q16 F3Q16 F4Q16 F1Q17 F2Q17 F3Q17 F4Q17 F1Q18 PCSD Mobile (273) (219) (47) (123) (206) (156) (155) (221) (173) Datacenter (40) (33) (13) (16) (64) (141) (124) (141) (144) Corporate unallocated 4 (58) (24) 30 (23) (22) (51) (97) (43) One-time expense - (923) Total reported PTI 52 (842) (69) Margin (%) PCSD 4.8% 4.6% 4.8% 4.7% 5.3% 5.2% 5.0% 4.3% 4.2% Mobile -15.0% -9.4% -1.6% -8.0% -12.1% -7.6% -7.1% -12.5% -9.9% Datacenter -3.7% -2.8% -1.0% -1.6% -5.9% -13.0% -11.8% -16.6% -14.8% Total reported PTI 0.5% -6.9% 2.5% 2.1% 2.0% 1.5% 0.8% 0.2% -0.7% Source: Company data, Morgan Stanley Research Source: Company data, Morgan Stanley Research 10

11 Valuation Methodology We revise down our price target to HK$3.6 (which implies 11x average F e EPS) due to the earnings cut in F e and also the valuation rollover from F2018e to one-year forward. We keep other key assumptions unchanged, including the medium term growth rate of 4.0%, terminal growth rate of 3.0% and the cost of equity of 9.3% (beta 1.1, risk free rate of 2.0%). The implied P/E multiple of 11x is in line with the PC peers' P/E multiple, which we view as justified given Lenovo no longer enjoys the valuation premium over other PC peers given the two sizable earnings drags from smartphone and datacenter hardware. However, we think Lenovo's leading position in the PC market (No. 2 PC market share) with higher OPM among PC peers (despite the margin contraction in the past two quarters) can support Lenovo to still trade in line with peers. The 11x is also at the low end of the historical P/E band, which we view as a reflection of slower profit recovery. Where we could be wrong? 1) PC margin recovers to 5.0% in 2H of F2018 thanks to product mix improvement, stronger shipment growth and price adjustment; 2) faster profit improvement at datacenter business thanks to the growth in oversea enterprise business; and 3) stronger than expected smartphone profit turnaround on the back of greater contribution from the overseas market. Exhibit 19: Lenovo: Residual Income Model US$mn FY2018E FY2019E FY2020E FY2021E FY2022E FY2023E FY2024E FY2025E FY2026E FY2027E FY2028E FY2029E Total Equity 4,298 4,686 5,034 5,347 5,673 6,012 6,365 6,732 7,113 7,511 7,924 8,354 Core Net Profit Return on Equity 9.2% 12.1% 11.3% 11.0% 10.7% 10.5% 10.3% 10.2% 10.0% 9.8% 9.7% 9.6% Beta Equity Risk Premium (Rm-Rf) 6.4% 6.4% 6.4% 6.4% 6.4% 6.4% 6.4% 6.4% 6.4% 6.4% 6.4% 6.4% Risk Free Rate (Rf) 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% 2.0% Cost of Equity 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% 9.3% Residual Income (3) Spread -0.1% 2.8% 2.0% 1.7% 1.4% 1.2% 1.0% 0.9% 0.7% 0.5% 0.4% 0.3% Yr-end Equity Capital 4,298 4,686 PV of Forecast Period PV of Continuing Value Equity Value 4,973 5,232 Fully diluted Shares 11,109 11,109 Projected Price (EoY)(HKD) Projected Price (EoY)(HKD) 3.6 Source: Morgan Stanley Research estimates 11

12 Lenovo: Quarterly Earnings Summary Exhibit 20: Lenovo: Quarterly Earnings Summary US$mn F1Q18 F2Q18E F3Q18E F4Q18E F1Q19E F2Q19E F3Q19E F4Q19E F2017 F2018E F2019E Net sales 10,012 11,416 12,663 10,150 10,154 11,251 12,136 9,759 43,035 44,241 43,300 COGS (8,648) (9,823) (10,826) (8,662) (8,662) (9,597) (10,357) (8,307) (36,929) (37,959) (36,922) Gross profit 1,365 1,593 1,837 1,488 1,492 1,654 1,779 1,452 6,106 6,282 6,378 Other income (expense) Operating expenses (1,371) (1,491) (1,486) (1,336) (1,357) (1,432) (1,467) (1,312) (5,444) (5,683) (5,568) Selling and distribution (665) (651) (649) (584) (593) (626) (641) (573) (2,681) (2,550) (2,433) Administrative (461) (504) (503) (452) (459) (484) (496) (444) (1,852) (1,919) (1,883) R&D (292) (335) (334) (300) (305) (322) (330) (295) (1,362) (1,261) (1,252) Restructuring cost/one-off items Other OP income (expense)- net Operating income (6) Non-operating income (63) (52) (40) (35) (47) (46) (43) (43) (182) (190) (179) Profit & Loss of Investment (0) Finance income Finance cost (72) (65) (55) (50) (59) (58) (58) (58) (232) (242) (233) Other income (expense) Pre-tax income (69) Income tax 15 (3) (22) (9) (15) (31) (47) (17) 41 (18) (110) Consolidated income (54) Minority interest 18 - (3) (3) (5) 12 - Net income (72) Adj.wtd.avg.shrs (m) 11,109 11,109 11,109 11,109 11,109 11,109 11,109 11,109 11,109 11,109 11,109 EPS (US cents) (0.65) EPS (HK cents) (5.04) Diluted EPS (US cents) (0.65) Diluted EPS (HK cents) (5.04) Margins Gross margin (%) Operating margin (%) (0.1) OPM excl. one time charges (%) (0.1) Pretax margin (%) (0.7) Net margin (%) (0.7) QoQ Sales (%) (20) (20) Gross profit (%) (0) (19) (18) Operating profit (%) NM NM 244 (57) (11) (55) Pretax profit (%) NM NM 522 (62) (24) (64) Net profit (%) NM NM 515 (62) (34) (64) YoY Sales (%) (0) (1) (4) (4) (4) 3 (2) Gross profit (%) (11) (1) (3) (2) (8) 3 2 Operating profit (%) NM (53) NM 118 (11) (8) NM (11) 35 Pretax profit (%) NM (70) NM 252 (13) (17) NM (17) 54 Net profit (%) NM (70) NM 206 (24) (28) NM (29) 38 Source: Company data, E = Morgan Stanley Research estimates 12

13 More on AlphaWise AlphaWise Reports & Interactives AlphaWise 13

14 Disclosure Section The information and opinions in Morgan Stanley Research were prepared or are disseminated by Morgan Stanley Asia Limited (which accepts the responsibility for its contents) and/or Morgan Stanley Asia (Singapore) Pte. (Registration number Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number H), regulated by the Monetary Authority of Singapore (which accepts legal responsibility for its contents and should be contacted with respect to any matters arising from, or in connection with, Morgan Stanley Research), and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N , holder of Australian financial services license No , which accepts responsibility for its contents), and/or Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N , holder of Australian financial services license No , which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited, regulated by the Securities and Exchange Board of India ( SEBI ) and holder of licenses as a Research Analyst (SEBI Registration No. INH ); Stock Broker (BSE Registration No. INB and NSE Registration No. INB/INF ), Merchant Banker (SEBI Registration No. INM ), and depository participant with National Securities Depository Limited (SEBI Registration No. IN-DP-NSDL ) which accepts the responsibility for its contents and should be contacted with respect to any matters arising from, or in connection with, Morgan Stanley Research, and/or PT. Morgan Stanley Sekuritas Indonesia and their affiliates (collectively, "Morgan Stanley"). For important disclosures, stock price charts and equity rating histories regarding companies that are the subject of this report, please see the Morgan Stanley Research Disclosure Website at or contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY, USA. For valuation methodology and risks associated with any recommendation, rating or price target referenced in this research report, please contact the Client Support Team as follows: US/Canada ; Hong Kong ; Latin America (U.S.); London +44 (0) ; Singapore ; Sydney +61 (0) ; Tokyo +81 (0) Alternatively you may contact your investment representative or Morgan Stanley Research at 1585 Broadway, (Attention: Research Management), New York, NY USA. Analyst Certification The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Melrose Chiu; Sharon Shih. Unless otherwise stated, the individuals listed on the cover page of this report are research analysts. Global Research Conflict Management Policy Morgan Stanley Research has been published in accordance with our conflict management policy, which is available at Important US Regulatory Disclosures on Subject Companies As of August 31, 2017, Morgan Stanley beneficially owned 1% or more of a class of common equity securities of the following companies covered in Morgan Stanley Research: Advantech, Alphabet Inc., Amazon.com Inc, Apple, Inc., Asustek Computer Inc., AU Optronics, Catcher Technology, Delta Electronics Inc., Ennoconn Corporation, Epistar, Facebook Inc, Flexium, GIS, HIKVision Digital Technology, Hiwin Technologies Corp., Hon Hai Precision, IBM, Innolux, LandMark Optoelectronics Corporation, Largan Precision, Lite-On Technology, Merry Electronics Co Ltd, Microsoft, Pegatron Corporation, Salesforce.com, Toshiba, TPK Holding, Tripod Technology, Wistron Corporation, Zhen Ding. Within the last 12 months, Morgan Stanley managed or co-managed a public offering (or 144A offering) of securities of Apple, Inc., Baidu Inc, Lenovo, Microsoft. Within the last 12 months, Morgan Stanley has received compensation for investment banking services from Alibaba Group Holding, Alphabet Inc., Apple, Inc., Baidu Inc, Hewlett Packard Enterprise, HP Inc., Lenovo, Microsoft, Tencent Holdings Ltd.. In the next 3 months, Morgan Stanley expects to receive or intends to seek compensation for investment banking services from AAC Technologies Holdings, Alibaba Group Holding, Alphabet Inc., Amazon.com Inc, Apple, Inc., Baidu Inc, Delta Electronics Inc., Ennoconn Corporation, Facebook Inc, GIS, GoerTek Inc, Hewlett Packard Enterprise, HIKVision Digital Technology, Hon Hai Precision, HP Inc., IBM, Lenovo, Microsoft, Salesforce.com, Sanan Optoelectronics, Tencent Holdings Ltd., Toshiba. Within the last 12 months, Morgan Stanley has received compensation for products and services other than investment banking services from AAC Technologies Holdings, Acer Inc., Alibaba Group Holding, Alphabet Inc., Asustek Computer Inc., AU Optronics, Baidu Inc, BYD Electronics, Compal Electronics, Facebook Inc, Hewlett Packard Enterprise, Hon Hai Precision, HP Inc., IBM, Innolux, Merry Electronics Co Ltd, Microsoft, Quanta Computer Inc., Salesforce.com, Tencent Holdings Ltd., Tripod Technology. Within the last 12 months, Morgan Stanley has provided or is providing investment banking services to, or has an investment banking client relationship with, the following company: AAC Technologies Holdings, Alibaba Group Holding, Alphabet Inc., Amazon.com Inc, Apple, Inc., Baidu Inc, Delta Electronics Inc., Ennoconn Corporation, Facebook Inc, GIS, GoerTek Inc, Hewlett Packard Enterprise, HIKVision Digital Technology, Hon Hai Precision, HP Inc., IBM, Lenovo, Microsoft, Salesforce.com, Sanan Optoelectronics, Tencent Holdings Ltd., Toshiba. Within the last 12 months, Morgan Stanley has either provided or is providing non-investment banking, securities-related services to and/or in the past has entered into an agreement to provide services or has a client relationship with the following company: AAC Technologies Holdings, Acer Inc., Alibaba Group Holding, Alphabet Inc., Amazon.com Inc, Apple, Inc., Asustek Computer Inc., AU Optronics, Baidu Inc, BYD Electronics, Compal Electronics, Facebook Inc, Hewlett Packard Enterprise, Hon Hai Precision, HP Inc., IBM, Innolux, Merry Electronics Co Ltd, Microsoft, Quanta Computer Inc., Salesforce.com, Tencent Holdings Ltd., Tripod Technology. An employee, director or consultant of Morgan Stanley is a director of Facebook Inc, IBM. This person is not a research analyst or a member of a research analyst's household. Morgan Stanley & Co. LLC makes a market in the securities of Alibaba Group Holding, Alphabet Inc., Amazon.com Inc, Apple, Inc., AU Optronics, Baidu Inc, Facebook Inc, Hewlett Packard Enterprise, HP Inc., IBM, Microsoft, Salesforce.com. The equity research analysts or strategists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues. Equity Research analysts' or strategists' compensation is not linked to investment banking or capital markets transactions performed by Morgan Stanley or the profitability or revenues of particular trading desks. Morgan Stanley and its affiliates do business that relates to companies/instruments covered in Morgan Stanley Research, including market making, providing liquidity, fund management, commercial banking, extension of credit, investment services and investment banking. Morgan Stanley sells to and buys from customers the securities/instruments of companies covered in Morgan Stanley Research on a principal basis. Morgan Stanley may have a position in the debt of the Company or instruments discussed in this report. Morgan Stanley trades or may trade as principal in the debt securities (or in related derivatives) that are the subject of the debt research report. Certain disclosures listed above are also for compliance with applicable regulations in non-us jurisdictions. STOCK RATINGS Morgan Stanley uses a relative rating system using terms such as Overweight, Equal-weight, Not-Rated or Underweight (see definitions below). Morgan 14

15 Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Global Stock Ratings Distribution (as of August 31, 2017) The Stock Ratings described below apply to Morgan Stanley's Fundamental Equity Research and do not apply to Debt Research produced by the Firm. For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively. STOCK RATING CATEGORY COVERAGE UNIVERSE INVESTMENT BANKING CLIENTS (IBC) OTHER MATERIAL INVESTMENT SERVICES CLIENTS (MISC) COUNT % OF TOTAL COUNT % OF TOTAL IBC % OF RATING CATEGORY COUNT % OF TOTAL OTHER MISC Overweight/Buy % % 26% % Equal-weight/Hold % % 24% % Not-Rated/Hold 61 2% 6 1% 10% 10 1% Underweight/Sell % 91 12% 15% % TOTAL 3, Data include common stock and ADRs currently assigned ratings. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months. Analyst Stock Ratings Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next months. Equal-weight (E). The stock's total return is expected to be in line with the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next months. Not-Rated (NR). Currently the analyst does not have adequate conviction about the stock's total return relative to the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next months. Underweight (U). The stock's total return is expected to be below the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next months. Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months. Analyst Industry Views Attractive (A): The analyst expects the performance of his or her industry coverage universe over the next months to be attractive vs. the relevant broad market benchmark, as indicated below. In-Line (I): The analyst expects the performance of his or her industry coverage universe over the next months to be in line with the relevant broad market benchmark, as indicated below. Cautious (C): The analyst views the performance of his or her industry coverage universe over the next months with caution vs. the relevant broad market benchmark, as indicated below. Benchmarks for each region are as follows: North America - S&P 500; Latin America - relevant MSCI country index or MSCI Latin America Index; Europe - MSCI Europe; Japan - TOPIX; Asia - relevant MSCI country index or MSCI sub-regional index or MSCI AC Asia Pacific ex Japan Index. Important Disclosures for Morgan Stanley Smith Barney LLC Customers Important disclosures regarding the relationship between the companies that are the subject of Morgan Stanley Research and Morgan Stanley Smith Barney LLC or Morgan Stanley or any of their affiliates, are available on the Morgan Stanley Wealth Management disclosure website at For Morgan Stanley specific disclosures, you may refer to Each Morgan Stanley Equity Research report is reviewed and approved on behalf of Morgan Stanley Smith Barney LLC. This review and approval is conducted by the same person who reviews the Equity Research report on behalf of Morgan Stanley. This could create a conflict of interest. Other Important Disclosures Morgan Stanley & Co. International PLC and its affiliates have a significant financial interest in the debt securities of Alibaba Group Holding, Alphabet Inc., Amazon.com Inc, Apple, Inc., Ennoconn Corporation, Facebook Inc, Hewlett Packard Enterprise, HP Inc., IBM, Lenovo, Microsoft, Tencent Holdings Ltd., Toshiba. Morgan Stanley Research policy is to update research reports as and when the Research Analyst and Research Management deem appropriate, based on developments with the issuer, the sector, or the market that may have a material impact on the research views or opinions stated therein. In addition, certain Research publications are intended to be updated on a regular periodic basis (weekly/monthly/quarterly/annual) and will ordinarily be updated with that frequency, unless the Research Analyst and Research Management determine that a different publication schedule is appropriate based on current conditions. Morgan Stanley is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Morgan Stanley produces an equity research product called a "Tactical Idea." Views contained in a "Tactical Idea" on a particular stock may be contrary to the 15

16 recommendations or views expressed in research on the same stock. This may be the result of differing time horizons, methodologies, market events, or other factors. For all research available on a particular stock, please contact your sales representative or go to Matrix at Morgan Stanley Research is provided to our clients through our proprietary research portal on Matrix and also distributed electronically by Morgan Stanley to clients. Certain, but not all, Morgan Stanley Research products are also made available to clients through third-party vendors or redistributed to clients through alternate electronic means as a convenience. For access to all available Morgan Stanley Research, please contact your sales representative or go to Matrix at Any access and/or use of Morgan Stanley Research is subject to Morgan Stanley's Terms of Use ( By accessing and/or using Morgan Stanley Research, you are indicating that you have read and agree to be bound by our Terms of Use ( In addition you consent to Morgan Stanley processing your personal data and using cookies in accordance with our Privacy Policy and our Global Cookies Policy ( including for the purposes of setting your preferences and to collect readership data so that we can deliver better and more personalized service and products to you. To find out more information about how Morgan Stanley processes personal data, how we use cookies and how to reject cookies see our Privacy Policy and our Global Cookies Policy ( If you do not agree to our Terms of Use and/or if you do not wish to provide your consent to Morgan Stanley processing your personal data or using cookies please do not access our research. Morgan Stanley Research does not provide individually tailored investment advice. Morgan Stanley Research has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial adviser. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. The securities, instruments, or strategies discussed in Morgan Stanley Research may not be suitable for all investors, and certain investors may not be eligible to purchase or participate in some or all of them. Morgan Stanley Research is not an offer to buy or sell or the solicitation of an offer to buy or sell any security/instrument or to participate in any particular trading strategy. The value of and income from your investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies or other factors. There may be time limitations on the exercise of options or other rights in securities/instruments transactions. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. If provided, and unless otherwise stated, the closing price on the cover page is that of the primary exchange for the subject company's securities/instruments. The fixed income research analysts, strategists or economists principally responsible for the preparation of Morgan Stanley Research have received compensation based upon various factors, including quality, accuracy and value of research, firm profitability or revenues (which include fixed income trading and capital markets profitability or revenues), client feedback and competitive factors. Fixed Income Research analysts', strategists' or economists' compensation is not linked to investment banking or capital markets transactions performed by Morgan Stanley or the profitability or revenues of particular trading desks. The "Important US Regulatory Disclosures on Subject Companies" section in Morgan Stanley Research lists all companies mentioned where Morgan Stanley owns 1% or more of a class of common equity securities of the companies. For all other companies mentioned in Morgan Stanley Research, Morgan Stanley may have an investment of less than 1% in securities/instruments or derivatives of securities/instruments of companies and may trade them in ways different from those discussed in Morgan Stanley Research. Employees of Morgan Stanley not involved in the preparation of Morgan Stanley Research may have investments in securities/instruments or derivatives of securities/instruments of companies mentioned and may trade them in ways different from those discussed in Morgan Stanley Research. Derivatives may be issued by Morgan Stanley or associated persons. With the exception of information regarding Morgan Stanley, Morgan Stanley Research is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we make no representation that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue equity research coverage of a subject company. Facts and views presented in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel. Morgan Stanley Research personnel may participate in company events such as site visits and are generally prohibited from accepting payment by the company of associated expenses unless pre-approved by authorized members of Research management. Morgan Stanley may make investment decisions that are inconsistent with the recommendations or views in this report. To our readers based in Taiwan or trading in Taiwan securities/instruments: Information on securities/instruments that trade in Taiwan is distributed by Morgan Stanley Taiwan Limited ("MSTL"). Such information is for your reference only. The reader should independently evaluate the investment risks and is solely responsible for their investment decisions. Morgan Stanley Research may not be distributed to the public media or quoted or used by the public media without the express written consent of Morgan Stanley. Any non-customer reader within the scope of Article 7-1 of the Taiwan Stock Exchange Recommendation Regulations accessing and/or receiving Morgan Stanley Research is not permitted to provide Morgan Stanley Research to any third party (including but not limited to related parties, affiliated companies and any other third parties) or engage in any activities regarding Morgan Stanley Research which may create or give the appearance of creating a conflict of interest. Information on securities/instruments that do not trade in Taiwan is for informational purposes only and is not to be construed as a recommendation or a solicitation to trade in such securities/instruments. MSTL may not execute transactions for clients in these securities/instruments. Certain information in Morgan Stanley Research was sourced by employees of the Shanghai Representative Office of Morgan Stanley Asia Limited for the use of Morgan Stanley Asia Limited. Morgan Stanley is not incorporated under PRC law and the research in relation to this report is conducted outside the PRC. Morgan Stanley Research does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors shall have the relevant qualifications to invest in such securities and shall be responsible for obtaining all relevant approvals, licenses, verifications and/or registrations from the relevant governmental authorities themselves. Neither this report nor any part of it is intended as, or shall constitute, provision of any consultancy or advisory service of securities investment as defined under PRC law. Such information is provided for your reference only. Morgan Stanley Research is disseminated in Brazil by Morgan Stanley C.T.V.M. S.A.; in Mexico by Morgan Stanley México, Casa de Bolsa, S.A. de C.V which is regulated by Comision Nacional Bancaria y de Valores. Paseo de los Tamarindos 90, Torre 1, Col. Bosques de las Lomas Floor 29, Mexico City; in Japan by Morgan Stanley MUFG Securities Co., Ltd. and, for Commodities related research reports only, Morgan Stanley Capital Group Japan Co., Ltd; in Hong Kong by Morgan Stanley Asia Limited (which accepts responsibility for its contents) and by Morgan Stanley Asia International Limited, Hong Kong Branch; in Singapore by Morgan Stanley Asia (Singapore) Pte. (Registration number Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number H), regulated by the Monetary Authority of Singapore (which accepts legal responsibility for its contents and should be contacted with respect to any matters arising from, or in connection with, Morgan Stanley Research) and by Morgan Stanley Asia International Limited, Singapore Branch (Registration number T11FC0207F); in Australia to "wholesale clients" within the meaning of the Australian Corporations Act by Morgan Stanley Australia Limited A.B.N , holder of Australian financial services license No , which accepts responsibility for its contents; in Australia to "wholesale clients" and "retail clients" within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N , holder of Australian financial services license No , which accepts responsibility for its contents; in Korea by Morgan Stanley & Co International plc, Seoul Branch; in India by Morgan Stanley India Company Private Limited; in Indonesia by PT. Morgan Stanley Sekuritas Indonesia; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main and Morgan Stanley Private Wealth Management Limited, Niederlassung Deutschland, regulated by Bundesanstalt fuer 16