Look Past Ericsson's Rough Near Term
Restructuring and industry headwinds have hurt results, but we still think the stock’s undervalued.
Ericsson’s (ERIC) second-quarter results were markedly better than those of the seasonally weak first quarter as the company aggressively worked down its costs and expenses. However, these positives were overshadowed by the negative near-term impact of restructuring activities and industry headwinds.
Ericsson expects its core wireless business segment to experience a high-single-digit revenue decline in 2017, worse than its prior forecast of 2%-6%. This will be compounded by managed services contract revisions that are likely to reduce revenue by as much as SEK 10 billion in 2019. We have reduced our fair value estimate slightly for the no-moat company, but we still see a decent margin of safety for patient investors.
Ericsson posted mid- to high-single-digit top-line declines year over year across all segments. Adjusted sales in the networks segment decreased 14% year over year due to continued weakness in wireless broadband deployments and lower revenue from the reduction in scope of a large managed services contract with Sprint (S). The segment’s adjusted gross margin declined to 30% from 32% a year ago as a result of lower revenue from highly profitable IPR licensing software.
Adjusted revenue in the IT and cloud segment declined 10% year over year due to lower sales of legacy products. Here too, adjusted gross margin declined to 28% from 36% a year ago due to ongoing challenges with profitability of large transformational projects and IT managed services contracts. Ericsson is in the midst of contract assessment and renegotiation work that has so far identified 42 unprofitable contracts. While this initiative is expected to significantly improve the profitability of the IT and cloud segment in the long term, Ericsson expects a decline of SEK 3 billion-5 billion in operating income over the next 12 months and a top-line headwind of as much as SEK 10 billion in fiscal 2019.
Ericsson will be decreasing its capitalization of research and development expenses, which is expected to have a SEK 2.9 billion impact on operating income in the second half of 2017. While the company announced another effort to take out costs by achieving a SEK 10 billion reduction in the annual run rate of expenses by mid-2018, its restructuring charges in 2017 are expected to be in the upper part of its previously announced SEK 6 billion-8 billion range.
Taking a step back, we welcome Ericsson’s efforts revitalize its operations and cut out unprofitable managed services contracts. The potential divestiture of the media segment and part of the IT and cloud operations will help even more. However, as the industry is getting closer to rolling out 5G in the next few years, Ericsson needs to tighten the execution of its restructuring program with an aim to be one of the leading vendors in all things 5G.
Bottom-Line Growth Has Been a Struggle
Ericsson is a top supplier of network equipment, software, and services to telecommunication service providers, but it has been struggling to deliver meaningful bottom-line growth. We like that the company is undergoing another restructuring effort to address its cost structure, but we don’t expect dramatic improvements, given the intense competition and strong buying power in the telecom equipment industry.
At its core, Ericsson is a leading provider of wireless communication equipment and services to carriers around the world, deriving 95% of revenue from this market. As waves of consolidation sweep across this industry, carriers are increasingly expanding, leaving vendors like Ericsson to compete for a handful of contracts. Meanwhile, low-cost Chinese vendors like Huawei and ZTE have been aggressive on pricing in order to win these contracts. These dynamics are well reflected in the industry’s low gross margins.
The mobile infrastructure marketplace is characteristically cyclical. As the demand for higher data throughput pushes the industry to adopt faster data transmission standards, carriers periodically embark on massive wireless network upgrade projects. Despite Ericsson’s attempts to diversify its revenue stream by selling various software solutions, the company’s top line still depends largely on the size and timing of network rollouts and upgrades.
Overall, we think Ericsson’s top line could grow at a low-single-digit pace over the next several years starting in 2018. The company has been investing in higher-growth-potential areas such as 5G, the cloud, and the Internet of Things. It is conceivable, in our opinion, that Ericsson will develop a strong presence in some of these markets, but we think it will be a while before its top line rebounds to historical levels. Until then, Ericsson has to rely on successful executing its restructuring program to deliver sound return to its shareholders.
Strong in Wireless Equipment, but Still No Moat
Consolidation among Ericsson’s customers and competitors, as well as pricing pressure from Chinese vendors, does not give us enough confidence that the company can generate excess returns on capital over the next decade, which precludes us from assigning an economic moat rating.
Ericsson operates in the telecommunication equipment market with particular strength in wireless equipment, as it delivers a full suite of hardware and software solutions directly or with its partners. Ericsson’s topnotch global services organization is capable of deploying and managing wireless networks of all sizes around the world. The company is known for its high-end equipment and services, which is a positive for profitability, but its premium pricing has provided opportunities for lower-priced Huawei and ZTE to take market share. In fact, per Gartner, Ericsson held 33% share in mobile infrastructure in 2009, while Huawei held 14% and ZTE held 8%. By 2015, Ericsson’s share had shrunk to 27% while Huawei’s had grown to 24.5% and ZTE’s to 12%. These market share shifts highlight the competitive nature of this industry.
We think the telecom equipment industry has significant switching costs once a product is selected by a carrier, as large-scale technology deployments--such as wireless infrastructure upgrades, implementation of operations support systems and business support systems, edge router deployment, and optical transport expansion--are very expensive and time-consuming projects. Some of these investments in infrastructure also tend to last well beyond the typical five-year lifecycle of enterprise infrastructure equipment. However, given intense competitive pressures, these projects are often deployed at zero or even negative margins in the hope of making up lost profits throughout the life of the contract by selling services, parts, and upgrades. This strategy is risky and often results in net negative projects.
The world’s largest telecom carriers are now starting to focus their efforts on moving away from proprietary hardware lock-in to the “white box” standards-based equipment. In this environment, we believe Ericsson’s decision to pivot away from hardware-centric business to a more software- and services-oriented model is strategically sound. However, with carrier infrastructure shifting toward software-oriented architectures, the barriers of entry decrease significantly, and we observe many smaller competitors entering this market.
The merger of Nokia (NOK) and Alcatel-Lucent has created a formidable competitor in the marketplace. Ericsson responded by signing a broad strategic partnership with Cisco (CSCO), which is in line with the overall company’s preference to sign partnership agreements with industry leaders rather than execute a large, complex merger and acquisition transaction. Altogether, we think Ericsson’s profitability profile and the competitive dynamics of this industry will prevent the company from earning excess returns on invested capital.
Price Pressure Remains Intense
Price pressure from Huawei and ZTE remains intense. Recently, Ericsson announced an expansion of its restructuring program that is focusing on, among other things, lowering its cost of products. We believe Ericsson will have to remain vigilant with its expenses in the foreseeable future to maintain decent profitability, ward off low-priced Asian competition, and address new threats coming from software-focused companies.
By signing a broad partnership agreement with Cisco and consequently reducing its investment in its IP line of products, Ericsson risks losing its internal expertise. While we agree that by focusing solely on the core business and growth areas the company can deploy its research and development resources more efficiently, we think that by forgoing internal IP product development, Ericsson will need to rely on either partnerships or mergers and acquisitions in the future, as restarting in-house development will prove prohibitively expensive and time-consuming.
There is a high degree of uncertainty around Ericsson’s investments in the so-called growth areas. Management has outlined 5G, cloud (NFV), OSS/BSS, and the Internet of Things as the key growth areas for the future. We think focusing on these areas is fully justified, but there are a lot of existing and up-and-coming competitors.
We forecast Ericsson to generate healthy free cash flow over the next five years and expect the company to continue distributing most of its earnings through dividends.
Ilya Kundozerov does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.