Company: Ericsson, Telefonab. L M ser. A & B
Written: Nov 2016
Authors position: Long, since July 2016
Weighted Average PPS: 50.61 SEK
Overview of Investment Thesis
- For the long term investor, who is comfortable with temporary red numbers, Ericsson provides an attractive opportunity as the shares are significantly undervalued.
- However, I would stress patience and don’t foresee a near-term quick fix as mobile broadband network spending takes a pause in certain regions.
- A dollar cost averaging strategy would be preferred as Ericsson expects the problems to continue into Q4.
Ericsson is a Sweden-based telecommunications giant that provides equipment and services to mobile and fixed network operators around the world. The company is the global leader in wireless infrastructure, with 40 percent of the world’s mobile traffic running through its networks. Its core network segment is the market leader in the network infrastructure industry and gives the company a better competitive position than many of its peers.
Even though it could be argued that Ericsson has a competitive advantage because of its scale, experience, and technological capabilities, it’s no secret that Ericsson has been struggling to deliver meaningful bottom-line growth. Increasing competition, a lack of structural barrier to entry, rapidly evolving technology, and industry consolidation has eroded Ericsson’s position as the industry market leader, and has depressed the stock price. The sell of in Ericsson, starting in April 2015, has frequently been referred to as “dinosaur slakt”, or translated “dinosaur killing”, by the Swedish investment community.
On the technological front, Ericsson faces intense competition from existing players as well as new entrants. Low-cost Chinese vendors like Huawei and ZTE have been aggressive on pricing in order to win these contracts. This pricing pressure has led to a gross margin squeeze across the industry. As a result of these two entering the market, a structural dent occurred, and Ericsson’s gross margins fell to the mid-30s from the mid-40s.
Consequently, many network providers have been forced to exit the market. In fact, Ericsson held 33 percent market share in mobile infrastructure in 2009, while Huawei held 14 percent and ZTE held 8 percent. By 2015, Ericsson’s market share had shrunk to 27 percent, while Huawei’s share had grown to 24.5 percent and ZTE’s to 12 percent. These market share shifts highlight the competitive nature of this industry.
As Ericsson’s core business is under attack by competitors, Ericsson has under the last years transformed into a greater services-based business, where the focus has shifted from hardware and equipment to software and solutions. The shift away from hardware is largely due to lower margins, high competition, and a sense of having an industry advantage in providing telecommunication services. The sales of the Sony-Ericsson, ST-Ericsson, and modems businesses highlight the key challenges found in the hardware industry. Nevertheless, the lack of structural barriers to entry does not ensure the longevity of software and services.
The diagram shows that Ericsson has under the last years transformed into a greater services-based business, as the segment Global Service has been growing from 15 percent of total revenue to nearly 50 percent. This has been achieved while the Segment Networks has been rather flat, contributing with close to 50 percent of the Revenue. We can also see that for the last 5 years, around 95 percent of Ericsson revenue comes from the two market segments Global Service and Networks. The rest of the 5 percent is produced by Support Solution.
Investors have also expressed longer-term concerns about technology risk. As wireless technology has been shifting toward an all-Internet Protocol architecture, Ericsson has been heavily investing in next-generation technologies and it is unclear whether these investments will generate adequate returns. Although 20,000 R&D staff and approximately SEK 30 billion in R&D spending per year is expected to shelter Ericsson from complete game changing technological shifts, the fast-paced nature of the industry does not ensure future technological leadership.
Ericsson admits that gross margins are at unsatisfactory levels, and has therefore since 2014 focused on improving its profitability by launching multiple restructuring effort to address its cost structure. The firm’s cost savings program is mainly focused on cutting R&D. Subsequently Ericsson has been forced to start a headcount reduction initiative in Sweden, U.S., Finland, Spain, and the United Kingdom, resulting in about 3,000 job losses in Sweden, where Ericsson employs about 16,000 of its 116,000 workers. Moreover, Ericsson’s workforce is much larger than it was in 2010 due to takeover activity and the difficulty of laying off staff. The firm’s cost savings program remains on track and is expected to continue into 2017 as Ericsson’s incoming CEO Börje Ekholm has suggested that cost cutting aimed at bolstering profitability will be his initial priority on taking charge of the struggling equipment vendor in January next year.
On Oct. 12, Ericsson announced weaker-than-expected preliminary results for its third quarter. Ericssons Q3 was in line with its guidance, reporting an overall sales decline by 14 percent YoY. Ericssons revenues are normally quite cyclical during the year, with the first quarters being the weakest, followed be each consecutive quarter being stronger. This is because the later quarters generally see the highest amount of activity due to seasonal purchase patterns of networks operators.
As we can see in the diagrams above, the revenue and the gross profit for the third quarter is weaker compared to the first and second. Ericsson explaines this as a result of strong headwinds in network coverage and capacity deployments of mobile broadband in Brazil, Russia, and the Middle East.
Remember that around 95 percent of Ericsson revenue comes from the two market segments Global Service and Networks. Seperating the revenue into these two market segments shows that Networks is the market segment that is falling behind the most, as Global Service has had stronger revenue in each consecutive qaurter for 2016. Adjusting for comparable units and currency the Networks segment declined by 19 percent YoY. The unfavorable revenue mix, toward lower sales of higher-margin broadband capacity (Networks), rather than lower-margin service revenue (Global Service), negatively affected Ericsson’s gross margin, which declined to 28 percent from 34 percent a year ago.
Comparing EBIT also highlights the current problems with the Networks Segment. As revenue has fallen to aggressive for the Networks segment, EBIT for the Network section has actually turned unprofitable.
The Networks segment delivers products and solutions that are needed for mobile and fixed communication, several generations of radio networks, IP and transmission networks, core networks and cloud. The main business driver in 2015 was mobile broadband network deployments. The major business models have so far been based on network coverage and network capacity expansions and upgrades with a revenue mix consisting of hardware and software. Despite a decreasing share of total revenue, hardware remains a core element of the strategy, representing some two thirds of sales in the segment. Network coverage build-out, which is mainly hardware related, is to a large extent done on site, while upgrades and expansions usually involve software and are often delivered remotely. A majority of the company’s research and development investments are made within Networks. In terms of share of segment sales, the North American region is the largest, followed by North East Asia.
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 is largely dependent on the size and timing of network rollouts and upgrades. The telecom equipment industry also 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, 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. Naturally, there is significant risk associated with the product and service development cycles. Products and services that do not gain widespread acceptance, function poorly, or are untimely, expose Ericsson’s competitive position and open the way for others to provide better products, services, and gain future favor from carriers.
Because of the cyclical characteristics of the Network segment, it’s not uncommon for Ericsson to see volatile revenue streams and fluctuating gross margins. Adding the fact that Ericsson has a fairly concentrated customer base with the top 10 largest customers accounting for close to 50 percent of revenues does not help with the volatile topline either. Taking this into account might shed some light on why the third quarter result was so terrible. The firm continues to face strong headwinds in network coverage and capacity deployments of mobile broadband, in Brazil, Russia, and the Middle East. This difficult spending environment was driven by macro-economic challenges, mainly in countries with high exposure to low oil prices.
Even though I think the Network segment sales will remain mediocre in the short run, the segment has significant upside potential in the long run as negative EBIT is not expected to prolong. This means valuing Ericsson after todays metrics would mislead investors because of a cyclical bottom valuation. A future of favorable revenue mix, toward higher sales of the higher-margin segment, creates a skewed risk-reward to the upside for the long term investor.
For valuation purposes, I advocate to capitalize Ericssons R&D. Capital expenditures are expenses that are expected to generate benefits over multiple periods; for instance, the cost of buying land and buildings is treated as a capital expense. Operating expenses are expenses that, at least in theory, provide benefits only for the current period; the cost of labor and materials expended to create products which are sold in the current period would be a good example.
While spending on equipment and factories may be adequate to define Capex for manufacturing and brick-and-mortar companies, those expenditures do not fully capture the true essence of technology firms that heavily invest in R&D. When it comes to technology firms, their biggest Capex, the R&D, is actually treated as an Operating Expense and not as a Capex, even if these spendings are expected to generate benefits over multiple periods. The treatment of R&D as an operating expense therefor has the immediate effect of lowering Cash Flow from Operations. For further reading about this topic: rd-expense
The diagrams below shows the difference between reclassifying R&D expenses as capital expenditures (diagram R&D included) versus leaving it as it is (diagram R&D excluded). Operating Cash Flow Margin (OCM) is calculated by adjusting Cash Flow from Operations (CFO) for Working Assets, non-recurring items and certain misplaced items. After using this adjustment, Ericssons Total Capex represent around 60 percent of OCM, compared to around 20 percent as before. Adjusting for these numbers are necessary, as Total Capex being around 60 percent of OCM represent a much more accurate picture of Ericssons business.
As seen in the diagrams below, OCM increases notably when reclassifying R&D as Capex, meaning the company will yield a significantly higher valuation when using Cash Flow from Operation as a valuation measurement. Ericsson has averaged around 16 OCM/share the last 5 years, implying a back of the envelope valuation of 80 SEK, assuming zero growth into the future and ignoring dividends.
As Ericsson has been struggling to utilize its Capital Expenditure to grow the company’s OCM, I, however, believe it’s misleading to use Cash from Operations to value Ericsson. Even if Total Capex is well below maintenance capex (adjusted depreciation), indicating that the majority of Ericssons current Capex is solely dedicated for future cash flow growth, I believe these numbers paints a too rosy picture of what’s really going on in the company. As the high Capex is a necessity to survive the fast-paced nature of the industry, I believe valuing Ericsson after its Free Cash Flow and its dividend sustainibility is more appropriate.
Excluding 2016, we can see above that the cost cutting program implemented by Ericsson has actually been somewhat successful. Between 2009-2015 Ericsson has shown impressive growth in both its FCF and its dividends. The current downturn has however made many analysts fear that Ericsson will cut its dividend, while some even see a risk that the dividend will be abolished completely for the year.
“We have removed the dividend for 2016 altogether and halved it for 2017 based on the year’s cash flow“, writes Carnegie in an analysis in which the estimate for the dividend for 2017 is 1.90 SEK, down from 3.70 SEK per share for 2015.
For Ericsson to slope its whole dividend for 2016 seems completely unlikely to me. The diagram below shows Ericssons dividend sustainability. Cash available to satisfy finance providers (CATSFP) is calculated by; OCM – (Invested)/Generated from Net Working Assets – Net Capex – Taxes. This is therefor the total cash available for dividends. CATSFP is calculated with a trailing twelve month average, meaning it might be a bit too high as an estimate for the full year, as the cash flows from Q4 in 2015 is expected to be higher than the cash flows for the Q4 in 2016, somewhat offset by higher cost & taxes in 2015 Q4 compared to 2016 Q4. I believe a conservative estimate for 2016 would be that CATSFP will be around 10-15 percent lower than the dividend for 2015. This would imply to me that it’s highly unlikely that Ericsson cuts the dividend with more than 10 percent for 2016. The most likely scenario in my opinion is that Ericsson leaves the dividend the same as in 2015, taking a small loan or sells a small portion of its short term investment to cover the remainder.
Discounted Cash Flow Simulation
Let’s simulate a discounted FCF analysis, considering a very conservative scenario where Ericssons Network segment will recover its profitability very slowly. I will let my growth assumption be normaly distribution with a mean of two percent. This growth assumption is well below Ericssons historical FCF growth and extremely reachable as the Network segment has huge upside. The two percent FCF assumption is in fact so bearish that it would take 10+ years for the FCF to simply recover to Ericssons prior 2015 level of 25 382 MSEK. As we can see our model values Ericsson somewhere around 90-110 SEK.
Let’s run a similar simulation, using the Dividend Growth Rate Model instead. Let’s assume the 2015 dividend amount as a starting point for the 2016 dividend amount. I then use a very conservative dividend growth rate of 3 percent growth (CAGR), taking into account that Ericsson dividend growth might lagg in the short term considering the company’s current problems. As we can see our model values Ericsson somewhere around 64-112 SEK.
As Ericsson operates in a mature industry subject to volatile revenue stream, up and downs can be expected. While recent margins has been terrible, I believe this is temporary due to shift in product mix and a cyclical Network segment. I think the Network segment sales will remain mediocre (flat to negative growth) over the short term given the cyclical slowdown in carrier spending from more mature markets. However, over the longer term, I anticipate a margin recovery that will work as a catalyst to drive renewed investor interest in the share. For investors looking to gain broad exposure to the network equipment and service industry, Ericsson present an attractive risk-reward oppurtunity with plenty of upside .