CELLPHONES – Smartphones Drag Down Lenovo

Bottom line: Lenovo’s latest results show its smartphone business continues to gain market share at the expense of profits, and it would be better advised to focus on building a strong brand to increase customer loyalty.

Lenovo smartphones post health sales gains

The latest results for leading PC maker Lenovo (HKEx: 992) don’t look too rosy, even as the company’s smartphone business continued to outperform the global market. There are quite a few pieces to this puzzle, which means the longer-term outlook for Lenovo’s smartphone business is still unclear as the overheated market undergoes a much-needed shakeout. The outcome of this story will be crucial to Lenovo’s future, since the global market for its core PC business is stagnating and even starting to contract as consumers gravitate to a newer generation of more mobile, specialized devices.

At the end of the day, the companies that survive the current smartphone shakeout will be those that can build up a brand with strong customer loyalty. The obvious leader in that regard is Apple (Nasdaq: AAPL), whose customers are true fanatics and will often pay hundreds of dollars more for an iPhone over a nearly identical model from one of the company’s rivals.

Chinese up-and-comer Xiaomi has shown an early ability for commanding similar customer loyalty, which is perhaps why the young company could currently be valued at up to $50 billion, based on recent reports. That’s around triple the current market value of Lenovo, which is a much older company and whose sales are much larger. But unlike Xiaomi whose phones are seen as cool and trendy, Lenovo’s smartphones are known for their cheapness — not exactly the kind of image a company needs for longer term success.

All that said, let’s zoom in on the results in Lenovo’s newly released quarterly report, starting with a top line revenue figure that grew by an anemic 7.2 percent to $10.5 billion. (company announcement) That was the company’s worst quarterly revenue growth in a year and a half, and the lackluster figure sparked a sell-off that saw Lenovo shares tumble more than 5 percent. The company’s profit actually grew by a faster 19 percent to $262 million, meaning Lenovo was doing a good job of controlling costs.

But investors were fixated on the smartphone story, which was a very mixed bag. At the broadest level, Lenovo’s smartphone sales grew by 38 percent based on units shipped, far outpacing the global growth rate of about 25 percent for the 3 months through September. But the picture wasn’t as rosy for Lenovo in China, its largest market, which passed the US to become the world’s largest smartphone market last year.

Lenovo didn’t break out specific China smartphone sales in its results, but it said that overall revenue in its home market contracted 2 percent during the quarter to $3.8 billion. Since Lenovo’s PC business in China remained relatively stable for the quarter and smartphone sales were probably up strongly by unit shipments, it’s probably fair to say that the revenue drop was largely due to falling smartphone prices.

At the same time, Lenovo’s China smartphone business is rapidly falling behind Xiaomi, which passed former leader Samsung (Seoul: 005930) to become the market leader in during the third quarter, according to one report. Lenovo did manage to come in third in China for the quarter. But even there, it seems to play a game of musical chairs for that third position with a number of domestic brands like Huawei that command similarly low levels of customer loyalty.

So, what’s the longer term outlook for Lenovo in light of these latest results? My advice to the company would be to stop fixating on market share, and instead concentrate on developing a brand and higher quality image for its smartphones. Lenovo may indeed take such a tack, following its recent purchase of older cellphone brand Motorola. That kind of strategy is Apple has done, and as a result its business is relatively stable unlike everyone else. Such a strategy may cause Lenovo’s smartphone sales in China to slow or even stall over the shorter term, but the longer term results should be more positive.

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