Although I flagged overly negative sentiment as a risk for Lenovo (OTCPK:LNVGY) shares in my prior update, it’s still frustrating to see, and these shares have continued to lag HP (NYSE:HPQ) and Dell (DELL) since my last update (and over the past year), as investors and analysts remain more fixated on the prospect of ongoing investments to build the data center business than on the successes in the PC business.

Older investors may be familiar with the expression of “don’t fight the tape”, and that’s not bad advice to a point. It seems as though Lenovo will face sentiment headwinds until and unless the DCG turns a profit, but I do believe the company’s investments here will pay off eventually. I’m willing to be sort-of patient about this (I will still complain…), and I continue to see Lenovo as meaningfully undervalued as assumptions of low single-digit revenue and FCF growth still drive a double-digit annualized potential return.

Another Strong Set Of Numbers

Other than gross margin, Lenovo did quite well relative to expectations this quarter. Revenue beat sell-side expectations by 9%, gross margin missed by a point, operating income beat by 50%, and pre-tax profit beat by almost 80%. Management also noted its expectations for above-average PC growth to continue through this fiscal year (ending in March 2021) and strong growth in data center spending for several years.

Revenue grew 10% in constant currency, or 7% as reported, with 10% growth in the PC business (including 38% growth in software and services, 19% growth in the Data Center Group (or DCG), and a 27% contraction in the mobile business). All business units came in ahead of expectations.

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Gross margin declined 110bp yoy and 230bp qoq, hurt by losses in the Latin American mobile business due mostly to COVID-19 lockdowns. EBITDA rose 21%, operating income rose 27% (margin up 60bp yoy), and pretax income rose 38%, with margin up 60bp. Once again, the PC business drove all of the profits, with pre-tax profits up 28% and margin up 90bp to 6.3%. The loss in the DCG business expanded slightly (about $6 million), while the mobile business reversed a tiny year-ago profit.

Ongoing Strength In PCs, Tempered By Component Issues

PC growth remained strong in the second calendar quarter, with IDC reporting 11% yoy growth in shipments. HP pulled back ahead of Lenovo this quarter, with a 25% share to Lenovo’s 24%, while Dell (less than 17% share) and Apple (AAPL) (less than 8% share) trail well behind.

Lenovo continues to see good demand across its business and continues to prioritize the development and sales of higher-margin products like gaming systems. Gaming laptop volume grew 78% in the quarter, while “thin & light” grew 71% and Chromebook grew almost 17%. Management also expressed its view that the strength coming from “work from home”, “learn from home”, and “play at home” will continue for a few more quarters. Looking at the reactions to the quarter, I’m amused by the bearish analysts who said the ongoing strength in work-from-home was “expected” when they were publishing Lenovo earnings preview notes in recent weeks calling for that driver to start fading meaningfully.

On the positive side, Lenovo continues to see good growth in higher-margin software and service sales within the PC business, with this segment now over $1B in quarterly revenue. On the negative side, component supply pressures remain an issue – both for volume fulfillment and margins.

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More Investments In Data Center

Within the 19% growth reported this quarter in DCG, Lenovo saw 21% growth in high-performance computing, 31% growth in cloud service provider revenue (probably driven mostly by Microsoft (MSFT)), 10% growth in services, and 9% growth in enterprise/SMB, an area that has long been weaker for the company.

Although demand in hyperscale remains good, Lenovo made it clear they will continue to invest in the business, including investing in improved design capabilities for both the hyperscale and enterprise segments. Investors took that as shorthand for saying the company would still be loss-making for some time to come. I understand the frustration here – the business hasn’t helped Lenovo since the acquisition from IBM (IBM) – but I do believe this is a “it takes money to make money” opportunity for Lenovo given the sizable opportunities in hyperscale data centers over the next decade.

Some Market Momentum In Mobile, But Does It Matter?

Mobile revenue has been hurt by consumer behavior shifts caused by COVID-19, but management tried to highlight that they outgrew the market in both Latin America (by seven points, boosting market share to over 19%) and North America (21 points of outgrowth, with 8% share). Although COVID-19 almost certainly has hurt this business, I believe many investors have all but abandoned the idea of this business as ever earning its cost of capital – the company is just too far behind Apple and Samsung in market share and customer perception – and it remains a drain on the business.

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The Outlook

Although I made some adjustments to my modeling assumptions, not much really changes. I’m still looking for revenue growth in the 2%s (closer to 2.5% now) on a long-term basis, with sub-2% growth in PCs and mobile, and mid-to-high single-digit growth in DCG. I expect gross margins to stay in the mid-teens, helped by improvements in DCG over time. I expect the operating margin to get to around 3% and more or less stay there.

The Bottom Line

Low single-digit growth is enough to support a double-digit annualized prospective return from here, and I’m not looking to sell my own shares in Lenovo any time soon. I can afford to be patient and let management prove its strategy for the DCG business. I still see sentiment as a near-term challenge, though, and I think investors will need to be patient for this one to work out.

Disclosure: I am/we are long LNVGY, DELL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.