Editor’s note: Lenovo’s latest earnings report showed a revenue rebound in its PC business in calendar 4Q16. However, the good news announced Thursday was overshadowed by the company’s ongoing challenges in smartphone and data center markets, says Technology Business Research Analyst Jack Narcotta.

HAMPTON, N.H. – Lenovo’s FY3Q17/CY4Q16 results show the degree to which the company’s Mobile and Data Center groups are out of sync with the dynamics of those markets, and how important its PC business — which accounted for 70.7% of Lenovo’s overall revenue in 4Q16 — is to the company’s overall financial health and future direction.

While increased demand for premium notebook PCs lifted PC and Smart Device Group (PCSD) revenue and operating profit year-to-year, steep unit shipment declines in its Mobile Business Group (MBG) and weakened demand for the traditional enterprise hardware offered by its Data Center Group (DCG) illustrate the challenges Lenovo faces rekindling demand for its smartphones and adapting to service-delivered customer and technology requirements in data center markets.

Initiatives to protect PCSD’s margins have paid off, granting Lenovo time and financial resources necessary to bring its PC go-to-market strategy, particularly in consumer markets, in line with market dynamics, as well as deflect some of the financial detriments resulting from stronger competition from Dell Technologies, HP Inc. and Asus.

In 4Q16 Lenovo noted strong growth in most premium PC categories, but especially in gaming and 2-in-1 PCs, that helped propel record-high global PC market share, according to Lenovo. While PC unit shipments grew a modest 1.9% year-to-year in 4Q16, to 15.7 million, the incremental gain easily outpaced global PC unit shipment decline.

Lenovo’s overall revenue declined 5.8% year-to-year to $12.2 billion in 4Q16, the fifth consecutive quarter of year-to-year revenue decline and the longest such streak since 2009. PCSD revenue in 4Q16 climbed 2.4% from a year ago, to $8.6 billion; MBG revenue declined 23.4% year-to-year to $2.2 billion; DCG revenue tumbled 20.1% year-to-year to $1.1 billion.

TBR estimates Lenovo’s revenue decline will slow in 1Q17, falling 2.5% year-to-year to $8.9 billion, nearly entirely due to weaker performance from DCG and MBG.

Lenovo’s strategies to protect MBG and DCG are failing, and risk wiping out the company’s operating profits

Uncharacteristically, Lenovo has been unable to fully integrate, and then revitalize, the underperforming assets it acquired from IBM and the former Google (now Alphabet). Even if Lenovo slows revenue and profit declines in its MBG and DCG segments, which seems unlikely in 2017 given recent top-level MBG and DCG management shuffling, it risks running into the red given its scattershot smartphone strategy and difficulty moving beyond a traditional hardware-centric data center value proposition.

Smartphone and x86 server pricing pressures are thinning MBG and DCG gross margins, and combined with the increased operating expenses required to build the scale necessary to slow MBG and DCG revenue declines are potent threats to Lenovo’s overall profitability, and complicate Lenovo’s ambitions to evolve beyond a seller of individual IT products and transform into an IT solutions provider. TBR believes Lenovo is aware of this risk, and has embraced a more disciplined and targeted approach to its smartphone and data center go-to-market strategies.

Placing premium smartphones at the center of MBG’s portfolio will help bolster margins, ease profit declines and insulate MBG against declines from the bulk of entry-level-heavy portfolios. Evolving its enterprise portfolio and strategic alliances to capture share of private and hybrid cloud migrations will better align DCG’s offerings with data center market dynamics.

However, even with these initiatives in play, TBR believes stout obstacles will remain for Lenovo in 2017, leading to continued year-to-year revenue and profit declines for these segments. DCG’s ongoing portfolio and go-to-market evolutions as customers’ data center architecture requirements evolve, and its inability to navigate turbulent, competitive and consolidating data center markets, have placed Lenovo on the defensive in the installed base it inherited from IBM.

In smartphone markets, MBG’s erratic cobranded go-to-market strategy and stronger competition, particularly in China from Huawei, Vivo and Oppo, diluted what remained of Motorola’s brand strength.

PCSD operating profit improved 6.4% year-to-year to $431 million, but operating losses in MBG and DCG robbed Lenovo of $112 million and $94 million, respectively, in operating profit. Thus, Lenovo’s overall operating profit plummeted 63.6% year-to-year to $138 million, generating an operating margin of 1.1%, the second-lowest margin for Lenovo since 2010, excluding the impact of the 3Q15 write-down of smartphone inventory. Exclusive of other operating expenses and financing costs, TBR estimates Lenovo will record an operating loss of $80 million in 1Q17, largely due to the burden of MBG and DCG operating expenses on shrinking smartphone and x86 server gross margins.