Editor’s note: Facing an “ongoing dive to the bottom in PC prices” as well as other challenges such as in its smartphone business, Lenovo is reorganizing its world-leading computer business. But will that be enough as Lenovo profits and revenue drop as the firm reported in its latest earnings report Thursday? Technology Business Research Analyst Daniel Callahan takes a look.

HAMPTON, N.H. – Lenovo, like other vendors, faces a singular yet pervasive challenge within the PC market: “good enough” technology and heavy competition conspires to create an ongoing drive to the bottom in PC prices.

Lenovo, which has been relying on its PC business to fuel expansion into adjacent markets, is particularly exposed to this trend. Seeing the future, the company reorganized its PC group into the PC and Smart Device Group in an effort to buck the market trend by promoting a suite of more useful product offerings and drive additional profits through increased efficiencies.

The company, which has successfully reorganized in the past, is embarking on a new set of changes to make possible its ongoing transformation from PC provider to top-to-bottom hardware purveyor for businesses and consumers.

Lenovo’s revenue declined 19.4% year-to-year to $9.1 billion in 1Q16, the first quarter since 1Q14 the company has dipped below $10 billion. Lenovo’s gross margin remained steady, growing 90 basis points, to 16.6%. However, gross profit declined 14.7% year-to-year to $1.5 billion in 1Q16. Lenovo’s gross profit and revenue declines are symptoms of the most prominent negative influencers in the PC and mobile businesses: weak demand and declining ASPs [average selling prices].

Vendors such as Lenovo can lower prices in an effort to stoke demand, but when the entire market’s prices are lower, it becomes a race to the bottom rather than stirring demand. Operating margins and operating profit have improved with a 160 basis point advancement to 2.7% and 94.9% year-to-year increase to $248.2 million, respectively. What the company called its “largest restructuring program in Lenovo’s history” is aimed at allowing the company to protect its operating profit through business reorganizations, layoffs and rearranged supply chains, all focused on improving Lenovo’s cost structure.

The lack of demand and lower ASPs are also alarming for Lenovo corporate. Since its Motorola and System x acquisitions, Lenovo has been leveraging its PC business as the fuel for consistent profitability and revenue to back the expansions into mobile and the more lucrative enterprise market.

However, with weakened demand and diminishing ASPs, Lenovo has been forced to look to these two new business groups for revenue and profit support far faster than TBR believes the company intended. TBR believes this haste has contributed to a muddled mobile strategy, which is uncharacteristic for Lenovo.

Lenovo has a clearer vision for the data center: focus on providing underlying hardware, leaving software and services primarily to partners. However, executing on this strategy will grow increasingly challenging as customers migrate quickly to comprehensive solution purchases that include converged and software-defined architectures, “as a Service” resource delivery and high-value consulting.

Lenovo’s new PC & Smart Device Group aims to strengthen its core PC business, but cannot easily change the underlying issues of the PC market

Lenovo is augmenting its go-to-market strategy to focus on useful versus utilitarian to move its PC customers up the ASP ladder. Its latest PC-based devices, such as 2-in1s and detachables, promise greater benefits to customers and therefore, for a margin- and profit-centric company such as Lenovo, a bump in pricing and more profit per unit sold. Gianfranco Lanci’s strategy centers on allowing Lenovo to attack growing segments, such as detachable and 2-in-1 PCs, without overextending itself and incurring operating losses. This is an aggressive but balanced approach, and we believe Lenovo placing Lanci as the overseer of the PC & Smart Device Group is a savvy move.

However, it doesn’t remedy what TBR believes are among the primary challenges for Lenovo and its peers: weaker demand shifting the bulk of vendors’ revenue mixes into lower, less-profitable price bands and the extension of PC life cycles resulting in part from greater availability of SSDs. While there is a growing appeal for devices such as 2-in-1s and detachables in portions of consumer and commercial markets, the narrower niches of these products, compared to their traditional notebook form factor cousins, will limit their ability to halt year-to-year gross and operating profit declines.

Lenovo’s mobile business stalls from inconsistent strategy in an extremely competitive market

TBR believes Lenovo is struggling to maintain momentum in the smartphone market, evidenced by the company losing its spot as a top five global smartphone vendor in 1Q16 by most third-party sources. In 4Q15 the company was the fourth largest vendor, but was supplanted by China-based brands such as OPPO and Vivo in 1Q16. TBR believes Lenovo’s troubles in the smartphone market stem from inconsistency in branding and portfolio, and trouble scaling Android phones.

While Lenovo’s manufacturing acumen fueled unit shipment and revenue growth of the Motorola portfolio, TBR believes that a glut of new, yet similar, Lenovo- and Motorola-brand devices and the resulting confusion among customers weakened Motorola’s position. At the outset of the acquisition, Lenovo focused its Lenovo-brand devices on the premium market and Motorola on emerging markets. In early 2015 Lenovo hinted it might retire Lenovo-brand devices in favor of Motorola-brand in mobile with Motorola taking over all design, development and manufacturing.

In January 2016 Lenovo reversed that decision, announcing the Motorola brand would be retired for Lenovo branding, only keeping the Moto branding. In May 2016 Lenovo announced the Moto G, known for its high-end performance and build quality at a budget price, will be split into three models effectively neutering the portfolio strength of that phone. Additionally, Lenovo announced two new ZUK phones in 1Q16, effectively competing with itself in the low-budget range in emerging markets.

This rapid change in strategy leaves consumers unsure of where to enter Lenovo’s portfolio and also hints that Lenovo is rapidly iterating in its effort to understand what the requirements of the various markets.

Meanwhile, rivals have matched Lenovo’s Moto specs, designs and extremely competitive ASPs in the $200 range with offerings such as the Oppo F1 Plus and Redmi Note 3. TBR believes Lenovo’s indecisiveness along with squelching of Motorola capabilities and forward-thinking members of the Motorola software and services team jettisoned in August 2015 layoffs further limited the availability of innovative features to differentiate Motorola phones.

TBR believes Lenovo will turn to managing the scale of its phone business, addressing what is the largest challenge facing Android OEMs. Yet as a well-equipped in manufacturing as Lenovo is and with its cultural focus on efficiency and swift decision making, the company will still experience significant challenges.

TBR believes Lenovo will focus its strategy on supporting customers in various markets, solidifying its brand and making profits at its scale in an increasingly competitive and varied global market against competitors that are reverse-engineering leading technology and offering rock-bottom ASPs.

(C) TBR