Analyst Note | Jul 17 2020
No-moat Ericsson's 1% year-over-year revenue growth (flat organically) in the second quarter was driven by strong demand for 5G infrastructure build outs, especially in the United States and China, being offset by weakness in other service offerings. Ericsson has inked deals with all the major Chinese telecom providers for 5G equipment, with the goal of gaining scale to lower costs in the long term in order to offset near-term margin pressures in that geography. The company is showcasing strong 5G progress, with 99 commercial agreements alongside having its radio and core equipment live within 54 networks. With an expectation for Ericsson to outpace market projections for radio access network demand in 2020, continued 5G strength in upcoming years, and traction in lowering costs longer term, we raised our fair value estimate to SEK 97 from SEK 91, and view shares as fairly valued.
Ericsson's networking business was the highlight of the quarter, with the segment growing 5% year over year. Network products were up 9% while network services declined by 2%. An inventory write-down for pre-commercial products and aggressive cost requirements in the Chinese market caused adjusted gross and operating margins for networks to dip year over year to 40.2% and 13.2%, respectively (from 41.4% and 15.0%). We expect the networks business to be the highlight of upcoming quarters with ample revenue growth opportunity with global 5G buildouts along with margin expansion as Ericsson benefits from its previous development efforts providing technological leadership and early 5G wins. In our view, ramping up the installation of 5G equipment as certain geographies race to upgrade their wireless infrastructure should give the networks business, and Ericsson as a whole, insulation from prolonged COVID-19 headwinds.
Compared with the prior year, Ericsson's digital services business declined 5%, managed services contracted by 12%, and emerging/other declined by 4%. Digital services' newer solutions grew by 18%, but services weakness partly due to COVID-19 impacted the results. Ericsson is ramping up its development spend in digital services to grab contracts at a pivotal time that coincides with 5G installations. This will impact the segment's operating margin in the near term; however, Ericsson confirmed its group level adjusted operating margin goal of at least 10% for 2020, and at least 12% for 2022 are intact. For managed services, the unit was affected by the Sprint and T-Mobile merger creating fewer variable sales after the businesses combined; also, Ericsson transferred a contract to one of its associated companies impacting its overall sales. In our view, CEO Borje Ekholm was very aggressive in his stance with Europe being left behind the United States and China for communications infrastructure. Ericsson used the earnings report and analyst call as a platform to state that Europe needs to ramp up incentives for digital infrastructure investments, including lowering the costs and availability of wireless spectrum. We find credence to the company's stance as the upgraded infrastructure can spur innovation across the technology realm as we saw with 4G infrastructure enabling new ventures outside of cell phones, like riding sharing.
Business Strategy and Outlook | 09 Apr 2020
Ericsson is a leading provider of hardware, software, and services to communication service providers. The company is off to a good start in 5G as carriers look to expand their network capabilities in the 2020s. 5G may have a longer spending period than previous wireless iterations, and we believe Ericsson's robust portfolio of hardware and software coupled with its industry leading services business has it primed to take advantage of 5G network demand.
The company has been on a turnaround mission after its 2015 apex. We believe that Ericsson is making wise strategic efforts and we applaud management's prudent outlook after slashing its cost of goods and operating expenses while committing to exit or renegotiate unfavorable contracts. We believe the management team has properly focused the company on invigorating networking innovation while honing operational efficiency.
That said, we do not believe the CSP equipment provider industry lends itself to economic moats because CSPs multisource vendors and flex pricing power by pitting suppliers against each other. However, we expect Ericsson's restructuring and strategic efforts, combined with 5G demand, to create top-line and operating margin expansion. We believe that Ericsson's efforts within software-defined networking will be fruitful as software becomes essential in a 5G world. Our expectation is for Ericsson to gain from 5G networks requiring many small-cell antenna sites to propagate the fastest transmission bands. Ericsson should profit from 5G networks creating more product use cases such as "Internet of Things" devices within cars and factories. Based on our view that network complexity will increase as firms control and monitor a rapidly growing quantity of Internet of Things devices, our expectation is for Ericsson's software and services to be in high demand. The company also creates revenue from licensing patents that are essential in the production of 5G smartphones (as well as previous generations). We believe Ericsson may find licensing opportunities in nonhandset markets, and that licensing revenue will help bolster operating results.
Fair Value & Profit Drivers | 17 Jul 2020
We are raising our fair value estimate to SEK 97 from SEK 91, which represents a fiscal 2020 enterprise value/adjusted EBITDA of 11 times.
We expect Ericsson to earn 3% revenue growth in 2020 and generate a five-year revenue CAGR of 2%, which is mainly driven by CSP 5G network build outs and additional 4G capacity demand. Additional revenue is expected from 5G networking solutions being used across a wider array of industries deploying Internet of Things devices.
In our view, Ericsson's operating margins will expand into the double digits by 2020 for a couple of reasons. We expect gross margins to expand into the mid- to high 30s, up from 23% in 2017 and 37% in 2019, through product costs reductions and selling more software. We expect Ericsson to benefit from selling higher-margin services to help simplify and manage complex networks as more Internet of Things devices touch 5G networks. Licensing revenue from 5G handset sales should increase Ericsson's margin profile. Additionally, management's focus on decreasing SG&A costs by making a more simplified organization should create operating margin leverage.
Scenario Analysis | 17 Jul 2020
Our bull-case scenario expects a five-year revenue CAGR of 4%. Within this scenario, we expect Internet of Things device proliferation and mobile network consumers to drive 5G network demand. Pricing competition would be tempered from market participants during the 5G building boom and Ericsson could experience strong licensing revenue from 5G handset sales. We also postulate that Ericsson's services teams may derive stronger revenue by managing and optimizing networks that should become increasingly complex as more Internet of Things devices touch networks. A mix of higher margin products would help drive Ericsson's gross margins beyond 40% in the bull case. This scenario also expects Ericsson to gain R&D and SG&A efficiencies as 5G products are rolled out, and we foresee operating margins increasing into the mid-teens. Our fair value estimate in this scenario is SEK 133 per share.
For our bear-case scenario, we expect a 2% five-year revenue CAGR. In this situation, we believe that 5G demand could create a difficult pricing environment as competitors scrap for CSP contracts. Enterprises and consumers may retain 4G and Wi-Fi services over 5G offerings if the benefits do not outweigh any additional costs. Lower 5G adoption would hamper Ericsson's services sales and we also posit that sales and margin could suffer from reduced licensing fees associated with a decreased quantity of 5G handset sales. We do believe that Ericsson would be able to extract operating margin leverage mainly through reduced SG&A costs. In this scenario, gross margins would remain in the -mid 30% range and operating margins would stay in the mid-single digits. Our fair value estimate in this scenario is SEK 64 per share.
Economic Moat™
We assign Ericsson with a no-moat rating and do not foresee the firm generating sustainable excess economic returns in the future. While we believe that Ericsson is one of the main benefactors of 5G infrastructure spending by communication service providers, or CSPs, our fundamental concern is the company's long-term ability to grow profitably against formidable competitors. Strategic shifts and cost reduction measures were necessary steps to facilitate Ericsson's ambitious turnaround plan.
Ericsson's operating business groups include networks, digital services, managed services, and emerging businesses and other. In 2019, network products and services for CSP infrastructure represented 68% of total revenue and generated had operating margin of 16%. The digital services segment was 18% of 2019 revenue, with a 10% operating loss, while managed services was 11% of 2019 revenue and had a 9% operating margin.
The networks business provides hardware, software, and service solutions for CSP cell networks. CSPs typically multisource their hardware and exert pricing power over network equipment providers since a small quantity of suppliers vie for a limited number of contracts. The equipment providers aggressively price hardware and attempt to profit over the life of CSP contracts through services and manufacturing cost outs. Ericsson, Huawei, and Nokia dominate the equipment provider market and benefit from being trusted hardware incumbents and technology leaders. ZTE and Samsung are formidable foes that are making the marketplace more cost competitive. Although we believe that Ericsson stands to benefit from CSPs building out 5G networks, the company also faces challenges as 4G networks become commonplace within highly cost sensitive geographies. The potential of 5G's speed is limited by its short distance range and interference susceptibility. Ericsson should benefit from 5G network infrastructure requiring small cell sites, but we expect limited upside as CSPs retain their multisourcing tactics.
Ericsson's digital services group, containing products and services for operating and controlling a network, was restructured to focus on products and software over services. The company is reviewing its contracts with a focus on profitability over top-line growth. As Ericsson reviewed and exited some contracts the segment revenue has contracted, and company management believes positive non-IFRS operating margin for the segment is achievable by 2020. We believe the segment's focus on 5G and cloud-based products should drive more value for CSPs and potentially create solutions for enterprises that will utilize Internet of Things devices on their networks. The managed services business, which operates and optimizes customer networks, is turning around its operations through contract reviews and automation investments. In our view, neither operating segment contains sustainable competitive advantages; nonetheless, increased network complexities due to 5G and Internet of Things networks could create demand for Ericsson's expertise and services.
An important revenue stream for Ericsson, and other CSP equipment vendors, are license fees that stem from patents developed while innovating communication protocols and technologies. For 5G NR, Ericsson's stated license fee is $5.00 per device or as low as $2.50 in lower average selling price handset markets (on an individual case basis). As a comparison, Nokia announced a maximum EUR 3.00 ($3.46 as of the Aug. 21, 2018 announcement date) fee per device with 5G NR capability and Qualcomm's rates are 2.275%-3.25% of the equipment price depending on the device type. Even though Ericsson will benefit from license fees, we do not see this as a competitive advantage over its largest competitors or a method to guarantee excess returns on invested capital.
Moat Trend
We provide Ericsson with a stable moat trend rating. After its large restructuring endeavor, we view the company as prepared to focus on extracting value from 5G network build-outs. In our view, Ericsson should benefit from CSPs creating 5G networks and enterprises utilizing Internet of Things devices. More small cell antenna systems should benefit the leading CSP equipment manufacturers; however, potential upside may be limited as leading competitors fight for contracts and 4G LTE networks become further cost competitive. We expect Ericsson to remain a frontrunner in networking equipment and services through its technology leadership and CSPs being fairly risk-averse with approving new vendors for mission-critical equipment and systems.
Ericsson's focus on nascent software trends like software-defined networking and network function virtualization should keep it as a preferred vendor to CSPs and enterprises requiring mobile networking solutions beyond hardware. As networks become more complicated and interconnected, Ericsson may benefit from CSPs and enterprises requiring external software expertise and network optimization, but we remain reticent to provide a positive moat trend since other market leaders and smaller players are also focusing on software to simplify complex networks. Internet of Things devices and 5G networks will drive demand for new antenna technology and networking software expertise, and we expect Ericsson and leading networking equipment provider peers to continue their market dominance through the 5G revolution.
Risk & Uncertainty
We assess that Ericsson's fair value estimate has a high uncertainty rating. Our expectation is for a competitive market with Huawei, Nokia, ZTE, Samsung, and Cisco vying for a limited number of important CSP contracts. CSP pricing requests could be unsustainable and may test Ericsson's fortitude of only engaging in value creating deals. Ericsson's turnaround efforts require considerable operational efficiency improvements that may not be established in a highly competitive marketplace. Higher margin items like software from Ericsson could be scorned for solutions from lower cost or pure-play software vendors. We note that price sensitive economies could drag down Ericsson's revenue and margin profile if the company cannot extract manufacturing and process efficiencies.
Ericsson's turnaround story coincides with 5G infrastructure build outs. If the promise of 5G's speed and capacity do not materialize or if 5G is too expensive to justify its benefits, then enterprises and consumers may forgo the new wireless generation. Growth expectations could be dragged down if Internet of Things devices do not expand at a significant rate or if networks do not require services faster than 4G. These potential risks would make Ericsson's 5G solutions limited in scope and the company could face turbulent headwinds.
An additional uncertainty are possible government restrictions on the usage of certain CSP equipment providers. In 2018, the United States and Australia banned its CSPs from using China-based Huawei and ZTE equipment in their network buildouts for 5G. A risk exists that the U.S. and Australia ban could be repealed, thus allowing greater competition from Huawei and ZTE in these regions. Similarly, China could favor domestic brands over Ericsson or influence other nations to use Huawei and ZTE over other vendors.
Financial Strength
We assess Ericsson as a financially stable company after making drastic changes that put itself into a position to prosper after a tumultuous period that coincided with 4G infrastructure spending declines. Our expectation is for Ericsson to generate steady free cash flow and be judicious with its cash deployments. Ericsson finished 2019 with SEK 52 billion of cash and equivalents with a debt to capital ratio of 31%. We believe that Ericsson will repay its outstanding debts of SEK 38 billion, as of the end of 2019, on schedule.
Our expectation is for Ericsson to focus its expenditures on R&D innovations while continuing to remove costs from its SG&A and product costs. As a percentage of revenue, we believe that R&D will remain in the mid-teens and SG&A in the low double digits. Ericsson has paid a steady dividend, although it dipped through its restructuring period, and we expect the company to gradually increase its payout as operating margin improves. The company does not have any stock repurchase plans.
Stewardship | 17 Jul 2020
We give a Standard stewardship of capital rating to Ericsson. In our view, the January 2017 appointment of Börje Ekholm as president and CEO spurred a company turnaround. Ericsson's entire executive team has been renewed since Ekholm's tenure as CEO, and half of the board members were elected since 2017. Although there are many new faces in important roles, we believe the team is doing a commendable job at this juncture. Ekholm, an Ericsson board member since 2006, has provided a focused rejuvenation plan while being forthright about the company's past issues regarding overextending its ventures and participating in unprofitable contracts. We believe the management team has done a commendable job in leading Ericsson through the repercussions that came from infractions of the United States Foreign Corrupt Practices Act that occurred before Ekholm took the helm. To focus on the core networks business, since 2017, Ericsson has jettisoned its power modules business, Montreal ICT data center, Swedish field services business, and sold 51% of its media solutions division.
Ericsson's two largest shareholders Investor AB and AB Industrivärden control 23% and 15%, respectively, of the total voting power of the company at the end of 2019. These large portions of voting control have been predominantly constant over the past few years, and we do note a level of risk inherit with concentrated ownership prioritizing its own needs before all shareholders.
The company pays a yearly dividend that was slashed for the recent turnaround efforts. We expect a gradual increase in Ericsson's dividend to be the primary source of returning capital to shareholders. As the firm takes a more judicious approach to capital deployment, we expect R&D for the core networks business to be the primary benefactor of investments. Ericsson completed the acquisition of Kathrein's antenna and filter business in 2019 to bolster its core offerings, and we believe this matched the company's growth strategy. In our view, Ericsson will focus on networking innovation and a streamlined cost structure to reward shareholders through earnings growth.
