Editor’s note: Lenovo’s earnings report last week shows that its revenue and operating profits declined as the tech giant struggled to balance protecting its margins and gaining scale in mobile and data center markets, writes Technology Business Research Analyst Jack Narcotta.

HAMPTON, N.H. – Lenovo’s puzzle to solve in 2017 will be how to break from its routine of resorting to protecting margins as revenue declines, and instead address how to reinvigorate its slumping businesses without overextending itself. In fiscal 2Q17/calendar 3Q16 Lenovo’s total revenue was $11.2 billion, down 7.8% year-to-year. Competitive pressures in PC markets from Dell, HP Inc. and Asus squelched demand for Lenovo’s notebook PCs; an erratic mobile device go-to-market strategy flattened smartphone revenue year-to-year; and challenges in EMEA and North America data center markets continued to create friction for Lenovo’s Data Center Group (DCG).

Lingering growing pains in its Mobile and Data Center business groups and stronger competition in consumer PC markets are forcing Lenovo to turn its attention to protecting its gross and operating margins as its overall revenue shrinks. Throughout calendar 2016 Lenovo has largely focused improvement efforts inward, electing to first protect its margins, then seek growth in select PC, mobile device and data center markets that promise greater profits. It has consolidated data center manufacturing facilities and reorganized its mobile device supply chain in an effort to reduce the burden on Lenovo’s largest segment, PC and Smart Devices Group (PCSD), to generate the bulk of the company’s gross profit.

Even though in a declining state overall, Lenovo’s gross margins are among the highest for the PC vendors included in TBR’s quarterly Devices and Platforms Benchmark, and the improvements year-to-year showcase Lenovo’s prowess as a manufacturer and its supply chain discipline as it pursues greater share in premium 2-in-1 and detachable PCs, higher-end mobile devices, and fast-growing data center segments such as analytics, cloud and hyperconverged. Overall gross margin improved 130 basis points year-to-year to 14.3%, in line with gross margin over the last 12 months, as Lenovo gleaned more efficiency from its streamlined supply chains. Overall gross profit climbed 2% year-to-year to $1.6 billion.

Persistent operating losses in mobile and data center segments, along with shrinking PC profits, weigh on Lenovo’s long-term ambitions

However, a chaotic mobile device strategy and stronger competition from entrenched data center market incumbents wiped out the benefits of higher gross margins. While operating margin improved 840 basis points year-to-year to 1.9%, the year-to-year improvement was skewed by a nearly $800 million write-down of unsold mobile devices in calendar 3Q15 that drove down operating margin, not profit growth from increased product and service sales.

3Q16’s operating margin was among its lowest in the last three years, with its Mobile and Data Center business groups the primary detractors, as those segments posted operating losses of $156 million and $144 million, respectively, with the latter the largest quarterly loss ever for the DCG, according to TBR’s financial modeling. In Lenovo’s PC segment, even as Lenovo remains the largest PC vendor in terms of unit shipments, the company’s lead is shrinking along with its profits. Dell and HP Inc. are gaining global market share at Lenovo’s expense, as their premium PCs gain favor with customers, particularly consumers in the U.S. and EMEA, weakening demand for Lenovo PCs and pressuring Lenovo’s PC average selling price (ASP), which hampers PC operating profit growth.

Lenovo’s ambitions to achieve its post-PC objective — transforming from a seller of IT products into an IT solutions provider — require its PCSD, Mobile Business Group (MBG) and DCG segments to work in tandem, reducing the necessity for the company to rely on PCSD for the bulk of revenue, profits and, arguably, new customer engagements.

PC ASP declines are slowing — PC ASP in 3Q16 fell 4.2%, to $507, the smallest decline in more than a year — which along with supply chain improvements helped spur incremental overall gross profit growth in 3Q16, but Lenovo’s inability to utilize its Motorola and System x assets to ignite overall revenue and profit growth highlights the obstacles ahead for the company through 2017.

However, even if Lenovo is able to reverse prolonged revenue and profit declines in its MBG and DCG segments, which it has uncharacteristically been unable to do despite a positive track record of integrating and rejuvenating underperforming business, TBR believes Lenovo’s bottom line is at risk of plunging into the red, which would effectively neuter its ability to utilize PCSD to bankroll to its longer-term initiatives. The greater sales and marketing investments required to support the scale necessary to increase MBG and DCG revenue is a potent threat to Lenovo’s overall profitability, and will complicate Lenovo’s path forward in PC, mobile and data center markets.

Personnel changes at the top of DCG and MBG are logical moves in response to unstable segment financial performance

In addition to its 3Q16 earnings, Lenovo announced the following leadership changes and appointments. TBR believes the moves, which come just eight months after Lenovo reorganized into its current PCSD, MBG and DCG segments, show Lenovo is reacting to difficult enterprise and mobile market conditions, and highlight its quick, calculated decision making to ensure the results generated by MBG and DCG are more in line with Lenovo’s objectives.

In DCG, Kirk Skaugen, previously the senior vice president of Intel’s Client Computing, Data Center and Connected Systems groups, was appointed executive vice president and president of DCG. Gerry Smith, formerly the executive vice president of DCG, was moved into role of the executive vice president and chief operating officer of PCSD.

In MBG, Xudong Chen will move from his role as co-president and senior vice president of MBG to senior vice president of Global Services. Mr. Chen will be succeeded by Gina Qiao, who most recently served as Lenovo’s senior vice president of human resources and, in the more distant past, chief strategy officer for Lenovo. Ms. Qiao will work alongside Aymar de Lencquesaing, who remains co-president of MBG.

(C) TBR