According to an article released by FinancialWire on 16 February, Lenovo received $22 million during Q3 in incentives from chip maker Intel as part of a multi-year package worth $100 million. In return, Lenovo agreed to reduce the number of chips the company buys from AMD, a bitter rival to Intel. Lenovo currently sources around half its chips from AMD, according to the article.
Confidential information obtained by FinanceAsia confirms that the $22 million incentive was booked under ærevenueÆ allocated to the company's Central Headquarters (CHQ) for the third quarter 05/06.
ôGiven that Lenovo did not break out these figures as an extraordinary payment, but bundled them in with the top-line revenue when it announced its Q3 earnings, it looks as if LenovoÆs intention may have been to keep this important piece of information away from investors,ö says an industry source.
As a result, the company was able to announce on February 2 that 3Q 06/07 earnings jumped to $57.7 million from $47 million a year earlier, beating market expectations of $56 million - although revenues were just about flat, up marginally to $4 billion from $3.98 billion.
ôThe impact of the incentive package effectively means that net earnings were boosted by $22 million, since Intel would have provided straight cash to Lenovo,ö says the source.
ôGiven there were no costs associated with the transaction, the sum would have dropped straight from the top line to the bottom line,ö speculated one observer.
In March 2006, Lenovo initiated a massive restructuring programme involving the laying off of 1,000 employees. The restructuring cost to Lenovo was about $100 million, but was expected to generate cost savings from Q3 onwards. Profitability was therefore an especially critical metric to investors in Q3 because investors were trying to gauge whether Lenovo's restructuring efforts had started to pay off.
ôInvestors were pleased with Lenovo's better-than-expected profit numbers, in spite of the company's flat year-on-year revenue growth, high expenses and increased competition in China. That boost to the bottom line was probably the only reason the company avoided serious selling pressure,ö speculated the source.
The sum involved in the incentive package from Intel is huge: in FY 05/06, Lenovo net earnings (net of restructuring charges amounting to $70 million) amounted to just $22 million, a fraction of IntelÆs total package.
The upshot was that by beating market expectations, Lenovo saw its share price surge 10% during intra-day trading in Hong Kong, before closing up 4% on February 2.
The following Monday, February 5, IBM offloaded 300 million Lenovo shares at $3.20, a 16.4% gain on the $2.75 the shares were valued at when the PC giant sold its personal computer division (PCD) to Lenovo in May 2005.
Observers point out that stripping out the Intel incentives brings down the net earnings for Q3 to $35.5 million. ThatÆs a decline on the $48.9 million figure of Q3 2005/6 a year earlier and a stinging indictment of the companyÆs inability to cut costs in its non-Chinese operations in the period since, say observers.
The fact that Lenovo did not separately break out the $22 million figure could have a serious impact on the Lenovo stock price, say sources.
ôLenovoÆs stock price went up sharply after the earnings announcement because analysts were convinced that the company was getting its costs under control,ö says a source.
Deutsche Bank, Morgan Stanley and HSBC all put out bullish reports on the stock on the basis that it had succeeded in controlling costs. Credit Suisse analysts bucked the trend and downgraded the stock.
Costs have been the Achilles heel of the PCD, which accounts for all LenovoÆs non-Chinese operations. The Chinese operations are successful, but Lenovo has not been able to rein in costs at the PCD. ThatÆs despite letting go two senior IBM officers: PCD CEO Stephen Ward, soon after the acquisition was completed in 2005, and Scott Smith, CEO of the Americas in January 2007.
According to a source close to Lenovo, the financial window dressing shows that Lenovo has failed to meet the cost savings it promised investors after restructuring the company in March 2006.
ôAnalysts estimate net earnings of $130 million in 2006/07 based on initial cost savings of around $40 million from the March 2006 restructuring. If you take away the $22 million it booked this year from Intel and a similar amount it also plans to book next quarter from the Intel incentives, then the companyÆs estimated net earnings for 06/07 are only around $78 million. That again is down on the $92 million (excluding the $70 million restructuring charge booked in Q4 05/06) in 05/06 û and shows cost-cutting is simply not working,ö says the source.
Another way of looking at it is that the cash injection would have reduced the cost of goods sold (COGS). Indeed, gross margins (a key industry metric closely followed by investors) for Q3 were 13.5%, up 0.5 percentage points quarter-on-quarter.
ôBut simple maths reveals that $22 million represents 0.55% of the companyÆs gross margin, based on revenues of $4 billion. So without the Intel cash injection, the gross margin would have shown no improvement, confirming that gross margins had not improved through cost-cutting,ö says the industry source.
Another aspect to the saga is the tax treatment, which came in at the unusually low level of 9% and thus also boosted earnings.
ôBut the tax treatment only boosted the numbers to $38-$39 million, which on its own would not have provided such a great impetus to the stock,ö estimates the source close to Lenovo.
Of the $1.33 billion the company estimates it spent on the acquisition of the PCD (on which it was advised by Goldman Sachs), a whopping $1.297 billion is classified as goodwill. One wonders how much ægoodwillÆ to the transaction is left now.
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