Ericsson (ADR) (NASDAQ:ERIC)
Q1 2016 Earnings Conference Call
April 21, 2016 08:00 AM ET
Peter Nyquist - VP of IR
Hans Vestberg - President and CEO
Jan Frykhammar - CFO
Alex Duval - Goldman Sachs
Sandeep Deshpande - JPMorgan
Richard Kramer - Arete Research
Edward Snyder - Charter Equity Research
Simon Leopold - Raymond James
Francois Meunier - Morgan Stanley
Garrett Jenkins - UBS
Kai Korschelt - Bank of America Merrill Lynch
Welcome to the Ericsson's analyst and media conference call for the first quarter's reports. To view visual aids for this call, please log onto www.ericsson.com/press or www.ericsson.com/investors. [Operator Instructions] As a reminder, replay will be available one hour after today's conference call. Peter Nyquist will now open the call.
Okay. Thank you, operator, and hello, and welcome to this Q1 call. With me here today, I have our CEO and President, Hans Vestberg, our Chief Financial Officers, Jan Frykhammar, and our Head of Marketing and Communication, Helena Norrman.
During the call today, we will make forward-looking statements. These statements are based on our current expectations and certain planning assumptions. They are all subject to risks and uncertainties. The actual result may differ material due to factors mentioned in today's press release, and discussed in this conference call. We encourage you to read about these risks and uncertainties in our earnings report, as well as in our annual report.
With that said, I would like to hand it over to Mr. Hans Vestberg for the first part.
Thank you, Peter. Okay. So let's take a quick look at the key developments in the quarter. We can only say that the momentum and the discussion on 5G, IoT and cloud from Barcelona has continued. It's the main topics of our discussions. The other is, of course, the digital transformation of our customers. Everything from preparing the virtualization for 5G, or preparing the OSS, BSS for a more customer centric way of working. That's clearly where we see our customer moving, and they are moving pretty fast. They are arising both opportunities and challenges. We're seeing the same markets having a weak macroeconomic environment this quarter. It's just that they haven't been in there for quite a while right now.
And both the currency fluctuations and the macroeconomic environment in these countries, of course, after awhile it becomes hard for our customers to invest, and where are markets like Brazil, Russia, Portugal, Middle East where we have now had this challenge for quite a while. And that remains, even though they are going from 3G to 4G demand in these markets, it is a more challenging environment there. We have less coverage product in Europe. One of the larger operators Europe have finished the big rollout of 4G.
So that, of course has coming to a halt. And you can see it in from our figures as well, that we have a decline in our European business. If you look at our sales, we continue with the same statement we had in three the third quarter and in the fourth quarter, that North America, our normal broadband is having a stable business for us. We had the good progress on IPRs in the quarter. We had a little bit mix in our gross margin, where we had a challenging quarter for global services, both from a network rollout point of view, but also the professional services point of view. And it happens from time-to-time, that we will have some challenges in services.
But we will also have a measurement that comes in quite quickly, and on the network rollout, where we need to adjust our service delivery resources, that we already started within the end of the quarter, and we will continue to pursue that in the second quarter. And then, some markets have certain labor rules and contractual agreements that it takes long a little bit longer. But here, we can adjust pretty quickly on the over capacity that we will had on network rollouts. The overall program, the SEK9 billion is tracking. It's coming in steps, but it's tracking, and we continue to execute on that, and that should be finished done in 2017, and that we still believe we can and should do.
If we then look at the result, we're flat sales, or 1% down currency adjusted. Low activity of rollouts in Europe and Latin America. I talked about that. We also had some lower sales in IP and core products in the network segment. As I say, at the same time, as we had a more stable situation on the radio side. The mobile broadband grew in North America and Southeast Asia. You will see that when we look at the regions, a good roll. And IPR, we had a good IPR quarter.
When it comes to the operating income, we went from SEK2.1 billion to SEK3.5 billion, a couple elements of that. Jan will come back to the bridges. But OpEx coming down, increased IPRs. Those are the positives. And then partly offset by the lower gross margin. That we'll come back to, but mainly driven about, from the service side, as well to a certain extent to IP and core. From a region point of view, we can see that we are a couple of regions, or quite many regions being in red. Some of them have these macroeconomic impact like Middle East, Latin America.
Then we have the European markets down. In the [IS], it is more about the new frequencies coming out, a little bit of a standstill. Remember, last year, we grew 100% in India in Q1, or at least close to 100%. So, of course that is now the comparison. Good side, North America, Southeast Asia, mentioned that region and other is IPR, broadcast services, some other activities, but mainly IPR is driving that good growth. Jan?
Okay. Thank you, Hans. We -- I will start with an update on the cost savings. Then the general message is absolutely in line with what Hans just mentioned. We have the cost and efficiency program, meaning the net SEK9 billion savings program, that where we feel confident that we will be able to deliver those during 2017. We also said in the Q4 report in January, that we are going to spend more time and effort on the cost of saves parts, which we are doing, and we continue to do. On the operating expense side then, SEK14.2 billion operating expense in Q1 compared to SEK15.6 billion a year ago. That's a significant decrease. Not all of it is related to the efficiency program -- I need to be clear on that. There are three items explaining the reductions year-over-year. The first one is increased capitalization on development expenses. I will come back to those. Then the savings related to the cost and efficiency program, and it is SEK500 million year-over-year. And then reduced amortization of intangible assets, which is in the neighborhood of SEK400 million.
So if you don't take the capitalized R&D expenses -- I have gotten so many questions during the day today, so I feel it's good for me to explain a bit more around those, in front of all of you here on the call. So I'll do that. We had a reclassification in the quarter between inventory and capitalized R&D of a little bit more than SEK200 million -- and that hasn't -- that doesn't have a P&L impact, if you look at the details around this in our detailed financial tables. The other important thing to understand is that the way we work here, is that for major R&D development, investment or project, then we capitalize. Then we capitalize the research and development expenses, and we start to amortize once we have reached general availability, and then they are amortized over 36 months or 3 years.
So there is a time lag between the additions here, and when the depreciations start. We can say in general, that we have had more capitalization during 2015. But, of course, as we now reach now GEA on several of these projects, we will start to see also increases in amortizations. So I think this big impact on the OpEx that we have had now for a few quarters will gradually over the course of the year start to become smaller. I got questions on that this morning. So I think it's important for all of you to understand this. Okay? Then if we go to restructuring charges then, we have also increased the guidance on restructuring charges with SEK1 billion. We had, the previous guidance was SEK3 billion to SEK4 billion full year. Now we say SEK4 billion to SEK5 billion.
The reason being that we feel, based on, obviously, the underabsorption we have in part of service delivery mainly in Q1, and also the more challenging outlook volume-wise for 2016, we feel that we need to reduce the size of the organization, which is something that we have already started to do in the first quarter. But we continue to do that in the Q2. We put an estimate to be SEK1 billion there, to be on the safe side. But the guidance is now SEK4 billion to SEK5 billion for the full year.
All right. Now we go to next picture. We take the currency exposure. The important thing to remember here is that again, we have the major currency, we have in terms of sales mix is US dollar. This is the full year picture last year, where we had US dollar 46%. It varies between quarters, but typically I would say between 42% up to 45%, 46% is what the typical US dollar mix.
You can see here then on the left-hand side, that we have -- we started to have, we still had tail wind in the quarter because these FX rates that you see here that are the ones that we use for the P&L. So measuring revenue for instance, you can see here that we have had tail wind also for U.S. dollars during Q1, compared to Q1 a year ago. However, we had head wind for many emerging market currencies. And that is clearly visible in the global services businesses, because you see that they have actually minus 4% reported, but zero adjusted FX sales growth.
I want to say that, if you take then the 8.11% there, which is the closing rate in March and then the revenue and P&L rate for April you see 8.11% compared to 8.60% a year ago that is 0.40 So if you take that times the typical mix, you will understand that there is a quite big impact on top line in April year-over-year. And if this rate continues, we will have an impact in the second quarter due to FX.
Okay, we take gross margin in Q1, we had 33.3%, compared to 35.4%. We had improvements compared to a year ago, mainly related to higher IPR revenues, but also higher capacity sales in North America, and we all remember that Q1 last year was a slow quarter in North America. Unfortunately then this was offset by lower margins in global services, but also higher share of mobile broadband projects or coverage projects in parts of Asia and also lower revenue or sales in IP and core networks. So those three things offset the positives with IPR and higher capacity sales in North America and then the quarter to quarter impact you see there in this picture.
If we look at the operating income, then the bridge 2.1 billion in operating income, SEK1 billion a year ago, SEK3.5 billion this year or 6.7%. Some impact on bottom line because of reported sales volume. The big negative impact is related to gross margin for the reasons I mentioned. And then, we have a positive related to operating expense and also positive related to a revaluation impact of the FX contracts. But I want all of you to remember that, this is one leg of the total FX impact. If I look at the positive and negative in the margins than a year ago and I would say that and this quarter, we are basically neutral, when it comes to net FX impact on bottom line.
Then if you look at operating income by segment, you see the strong improvement year-over-year in networks. So Q1 a year ago, we had a really weak networks quarter. Now we've had a better networks quarter this quarter for all the reasons that we have discussed and Hans will briefly come back to. Services is really where we have the challenges this quarter. After many strong quarters, we have a weak services quarter, and we also take measures on that.
And then on the gross cash side, a change in gross cash of minus 5.3 billion between end of year last year or during Q1 in 2016. We have also changed the definition of net cash to exclude post employment benefits. We still disclose the post employment benefits, but the reason being we have looked at different companies and how they do this. The second reason is, of course, that in this low interest rate environment, but also somewhat volatile interest rate environment, you get big swings between the quarters here on the post employment benefits. And these are maturities that are very long, so we feel it's a better way of explaining the net cash. Okay, Hans. Now it's you.
Thank you, Jan. Coming into the segments, starting with networks much has been said when we go through the bridges, and what is happening in networks. Down 3% for currency adjusted but you can say as we said, we had a lower software sales in IP and core. On the other hand we had a more stable radio business especially North America and Southeast Asia.
India, I talked about before. There are some lower investments there because the spectrum auctions. And we can also see that the European sorted by mobile broadband deployment is all completed and actually slower in pace.
Operating income, Jan went through that, and what is fueling then the improvement with SEK2.1 billion. Two things on the business, we acquired NodePrime that is working with our and being a supplier to our HDS 8000 and that we acquired in the quarter. But also important is that we are now ramping our Ericsson Radio System and the larger volumes will come at the end of the year. But it's a very important milestone for us with a new product very efficient. Very much lower footprint as well as energy consumption, and high carriability.
Services, where Jan had talked about, we had a flat quarter. However, net rollout down 12%. As Jan talked about, in services, professional services, then more flattish. Here, where as Jan said, we're coming down in profitability. It's a long time since we were that low on professional services. Network rollout as Jan said, that we're adjusting immediately, and that's more about having that we have overcapacity, and we are now addressing that quickly. On professional services, all the time, as I said at the morning's progress conference, I'm confident that we should be there between 12% to 15% operating margin professional services. Right now, we have some growing pains in the system integration. And that's is good, I would say because we are gaining a lot from new contracts, large OSS and BSS transformation.
And remember, from the Capital Market Day, where we showed one of the deals, where basically 25% is our own software, 25% is our third party software, and then 50% is system integration. So, of course we are driving more system integration than our own products in these type of businesses. So we need to have that in mind here. But again, on the network rollout, we are taking corrective measures, had a good business uptake with 21 new managers contracted in the quarter, and 13 CSI contracts. Support solutions, slightly up of course helped by the IPRs. Here we have a little bit more stable, OSS, BSS and TV and media business, a little bit lower software licenses. We are moving into recurrent business here. So we are constantly transforming the portfolio, but it takes some time as we take new deals.
We can also say that, that the more and I talked about a digital transformation on OSS and BSS is high, and we have some really large projects that we are doing right now. But they are mainly impacting system integration, and that's where we are. Good, I will then just come back to or talk a little bit about the changes, the structural changes that we have announced today as well. And on the high level, you can say we are setting a new company strategy, following more or sort of our investment areas. So we can follow the target areas much better. We can follow the core areas that we have talked about to many of you, and during two years, kept them obviously.
We are now setting a structure. And we are doing it for two reasons. One is of course, that are customers are moving there. Two we have reached a scale of it, so we can actually have a unit focused on IT cloud, and IT cloud and services and media. So that is one of the reasons. The other reason of course, that we are accelerating our strategy execution. And we have said it before, we even though there are external environmental things, we are not happy with the growth that we have had. And we have also said that, we want to gradually continue to improve our profitability. So we are putting a structure that has an even higher chance to execute on that. And the timing is well defined, as we have now reached a scale and we have sort of reached the different type of the mature ability from type of businesses.
So it's a lot about the customer, and the requirement and to capture the market place where we have invested. But it's also that we have designed this structure different from the previous structure, where we have more end to end thinking, more possibilities to impact from a global point of view. And we treat the different businesses differently because they are in different stages and have different demands. I mean the networks business, we just want to continue the world leader. Both drive efficiency, but also lead in the 5G, with all the product and services. IT and cloud, of course is very much about the digital transformation we're doing with customer virtualization, where the product area and the software is enormously important to get leverage from as well as the system integration. And those two together should of course create the target area possibilities.
And media, we've put together as one unit, with both broadcast services and products in order to have an end to end possibility to impact there. So, I think that's very important. That also means that we made a lot of new appointments today, as we're going into this next phase, and a new leadership team is appointed with several new members with a long track record and background, and of course very strong individuals coming in here. This will be from the first of July, this organization works. And the reporting wise, we do it of course by fiscal year, and from a reporting point of view this organized structure will be reported from the first of January 2017. So we can talk about, that we have done a lot of things. Yes, we the last five years were tremendous changes doesn't really matter. We still have challenges. We have had challenges on the growth.
We have grown well in the target areas, as you will remember from last year. We're now nurturing that business, at the same time taking care of our core business in networks. The profitability has gradually improved. It was 7% operating margin in 2014, 9% in 2015, and we have a high ambition to continue that journey, this structure to support that strategy execution and accelerate it. So in simple terms, we keep the 10 regions, but the regions have a smaller responsibility. We're extending the business units further, when it comes to ownership of supply, service delivery, all in order to dimension and have a much bigger accountability for the business units.
We're also creating the three customer groups. IPR, we have had all the time, going direct to the customer. Media will also go direct to their broadcast and cable customers, in order to see that we're leveraging that on the right way. And then we are lifting the industry society customers, the utility customers, the transport customers and the public safety customers, also to have an end-to-end responsibility to see that we are really driving the possibility to have a 20% to 25% of our revenues coming from non-operators, meaning cable operators, media operators, public safety, utility, IPR customers. That area we want to have 20%, 25% in 2020, as we disclosed at the Capital Market Day in November last year.
So this is how the organization structure looks like. We will not dwell much more on that. You will see that we have very clear clustering between the network unit and the service units. The product and services units for networks equally for the IT and cloud product, and service units. We want them to work together, make it easier for our customers to do business with us, and find efficiencies when you do it. And that's also why we are mirroring the way we go to market in the regions. At the same time, you can see the customer groups there in below. If you then, just to get an overview, networks will be 70%, where the service piece is somewhat smaller or smaller than in the networks or the product side, but not that much. 25% of our turnover will be in IT and cloud. And here it's really not the same, but almost the same on the sizes between the services and products. And then 5% is the media, where you have one unit. That's basically if we do it pro forma from 2015. So you know more or less, the sizes of these ones.
Addressable markets, both the networks and IT and cloud, combined in technology and services are $100 billion businesses, but they are growing differently. They have a different market and dynamic. And media is $14 billion, which also have another different dynamic. And you can see what products and what services product are going into these different segments. I have mentioned quite a lot about how this will benefit us from efficiency. But it's of course, a simplified structure, much more mirrored, much more end-to-end, in order to drive accountability. We will also have a closer set up between the product and services, which would make this a much speedier, and we are going to get more scale. And efficiency, we will have much more end-to-end responsibility. We will have [duplications] that we can take out in research and development, as well, when we combine certain elements here. So that's on the efficient side.
On the customer side, of course, our customers are evolving like this as well. Now the networks, that have the digital transformation. And of course, they have the media, so that is many of them. So I think that here, we will have a possibility to really support them. And it will make it easier, as we will work much closer between technology and services, as many of the areas. The strength is that you have system integration, and then OSS, BSS [offer]. You have it both. And Ericsson is one of the strongest competitors known to have. We have those, both of those. And that means that we can really execute better, and easier for our customer. And it's part of the digital transformation that's happening. So, Jan, then coming back to your -- the improvements, the profit improvement ladder that we have, showed at the Capital Market Day, what does it mean for that?
Okay. So I think, a couple of main messages here is that, we will continue to look at the profit improvement plan, and the potential of the Company in these three different buckets that you can see on this picture, meaning efficiency, monetized footprint, and build success in targeted areas. I think, efficiency is clear. We have the SEK9 billion net savings program. Some of the things that Hans mentioned are important here, from an efficiency point of view. For instance, making sure that we can dimension supply and service delivery more end-to-end, to also reduce a bit of the volatility that we have, and also experienced now in Q1 for instance, in terms of utilization of resources. That's one example.
Then the monetized footprint, of course, to have services and product businesses very close to each other. It's focusing on our main customer base, the operators as they transition the business from 3G to 4G, and 4G to 5G to make sure we are relevant for them, stay close to them and so forth, it's important. And then, build success in targeted area. Here we will have now business units with clear accountabilities to deliver the business cases here. If we take the next then. So if we take the five business units, that then will be in place from July 1 of this year, our intention is then to change the segment reporting externally, to reflect all of these five business units. We will do that then, beginning January 1, 2017. So, the first time that you will see these new segments will be at the quarter report then in April I guess of 2017.
We will come back with more information to all of you at the Capital Market Day in November. And we will do our best to restate numbers as soon as possible and also to get them audited. And for sure, we will make sure it will happen in the beginning of 2017, so you have enough time to adjust your models, and understand performances and so forth. So with that, back to you, Hans.
Yes. No, I have basically have nothing more to add. Again, we're putting a structure in place, in order to accelerate the strategy execution. They're two reasons, one is the external customer dimension that we have created scale in these areas that we call the target areas, in order to have a fully blown organization to really execute on it. The second is that we think that we can really execute even stronger and harder when accounts growth as well as profitability improvements. And that's in our [indiscernible] to see that we are doing that. So that's what we are announcing. And that also means that there have been several new appointments in the leadership team, in order now to stack up this organization as valid from the 1st of June -- July, I should say, 1st of July 2016. Many dates here and that's about it.
Thanks, Hans. With that, I would like to invite you all for the Q&A session. So operator, you can open up please, for questions?
[Operator Instructions] Our first question comes from Alexander Duval of Goldman Sachs.
Yes, good afternoon. It's Alex Duval from Goldman Sachs. I had a couple of quick questions. My first one is on gross margin, which is obviously about 200 bips below market expectations when adjusting for the patent's catch-up in the first quarter. So it looks like for the last two or three quarters, those have been challenging. Could you just help us understand in a bit more detail what precisely is driving that? The reason I ask, is it looks like regions like North America and Japan were actually quite decent on the network side and they typically have better gross margins. So I'm just wondering, are you engaging in discounting on pricing? Is competition getting harder given the broader tough conditions that you referenced in your introductory remarks?
And second of all, if I look at 5G, you talked about the excitement around that and clearly, there's work being done in terms of in setting standards. But when should we really think about the first large scale rollouts? Is 2020 a reasonable time frame to be thinking about that? And if that's the case, then should we really be preparing for radio base station declines realistically for the next few years? That would be very helpful, to get some color. Many thanks.
Okay, Alex, it's Jan. I'll take the first question, and I then hand over to the boss for the second question. So on gross margin then, it is the way I tried to tell you. It is we had obviously the positive driven by the IPR revenue and also by the positive driven by mainly capacity in North America. I mean, to a certain degree [indiscernible] but it's mainly in North America. That's why it's written in the report. And then, it was unfortunately offset then by lower margins in the first quarter, driven by the things I mentioned which is then global services, lower revenue in the core and IP area and it's mainly we had last year's Q1's strong and impact core business in North America and also big core or routing deployments in mainland China that we don't have this year. So those are the challenges.
I think on your second part of that same question, we have had a challenge in gross margin for a few quarters. We have had a business mix for a few quarters and that's also applicable for this quarter which is smaller coverage and hardware-centric business so that is impacting the mix. And the most important thing remains to be capacity versus coverage when it comes to defining the impact of the gross margin.
And then on your question around competition and pricing and so forth, there is nothing new there. We are acting and living in a very competitive market. That has been the case for many quarters and many years. Every time there is big deployments on coverage and so forth the new footprint available, it has impact on the commercials. So that is the same the way it has been now for us for many years. But the things I mentioned on gross margin in Q1, are the important things for you to understand.
Hans, on the second question, I'll to you then.
Large commercial 5G deployments, that has to be beyond 2018. Of course, the standard by rules will be set 2020, so that is when we will see. We are going to see trials, and we've already announced we have 21 operators we're working with already. We have academia, and different type. And that's when we are setting the standard, but meaningful, large scale deployments after 2018, I would say 2020, but I want to be a little bit cautious, because I know that some markets really want to do a pre-commercial or pre-standard 5G. So let's see.
I think, the most important that is there's still a big transformation of 3G to 4G happening in the world. I mean, they're a couple of markets that has completed the forum for 4G. But the majority are still on 3G, and we still have 2G as well. So that's coming, and that's of course, it's a prediction or evolution to 5G to make that. Because that means you need also change part of your core and all of that, that if application for 5G. So I think that's important. But as always, where you have sort of a coverage phase of a technology, and then you have a capacity phase. And that, where they're in different place in the world all the time.
Alex, are you happy with that answer?
Thanks. Next question please?
Thank you. [Operator Instructions] And our next question comes from Sandeep Deshpande of JPMorgan.
Yes, hi. Thanks. My question is regarding the services business itself. The margin in services was very low, and you cite the new contracts ramping up. But when we look at the revenue in services, the revenue services is down in professional services, down year-on-year. So can we try to understand the dynamics of what has happened in the services businesses, which has taken the margin down year-on-year, and will this persist through the year?
I think that's an excellent question. And remember, I think that we'll had10 years of fairly consistent margins, and now and then we come down. So I think first of all, we should have all at least we have the confidence that professional services should be in the range we have talked about. So there are two different things happening with the margins. I mean, we're basically flat on professional services in constant currency, and we're down 12% in I think in network rollout. So there are two different dimensions here. On the network rollout, we have overcapacity, and that we are now addressing.
We already started in March. That is sort of something that temporary we can do. That my depends a little bit on laws or regulations, labor rules, etcetera, how fast you can do it within certain markets. If it's Europe, for example, it's a little bit slower. If it's Latin America, it's a little bit quicker. But that we have already started there. When we look at the professional services there, it's a growing pains in system integration. That margin has come down, very much driven from that we have gained a lot of large digital transformations. And here, it's more about starting this up, have the right people at the right place etcetera. So we are in the beginning of that journey, with a couple of really large product.
That may take a couple of quarters more to when they come back to normal. But it's basically like you're getting a lot of new system integration projects here in the beginning. And then over time, that will even out, of course. But I think, that's the two dynamics that we see in the margins. Jan, do you want to add something? No, but I think we'll sit. I think should be humble to what we report here. Hans and I, we have talked a lot about this, and also with among us. I mean, we have it is not easy to dimension services, especially between the fourth quarter and the first quarter, because fourth quarter is very high on activity level. And then typically Q1 is lower on activity level.
This was a very big change between those two quarters this year. And I think we should have seen some of this a little bit earlier, I agree. But it's still not easy, and we are irritated on this one, and we also take action. But yes, to be clear. It is not simple to see this between Q4 and Q1, because Q4 is such a high activity level, and then it drops significantly in Q1.
Okay. Thank you.
And we should add to that, that the new structure we are putting into place, we will have an easier way to adjust these types of things, as we're moving more resources to the global centers, which means that we can adjust on a global level much quicker. Not saying that our regions are not doing it, but it's harder to see when you are sitting close to it. So that's part of the adjustment, and that's why we say we designed the organization to be even more efficient. Then you can always ask us, why haven't you done that earlier? I think the answer to that is, we have come to such a size in services, we can run this on a global level, talk the difference and we can even split services and still have scale in them. So, I think the timing is right. But I think Jan's comments are important as well. We are a little bit sad about this development, but we are taking corrective actions immediately here.
Okay, Sandeep? Okay, operator, we're ready for next question, please?
Thank you. The next question is from Richard Kramer of Arete Research. Go ahead, your line is open.
Thanks. Two quick questions, please. For Hans, given that you're adding eight new members to your executive leadership team and you're restructuring, and you mentioned all the challenges, can you talk about taking on the role of the Swedish Olympic Committee and how many man hours are you going to take doing that? And is this the right time for a distraction like that? And for Jan, when you're looking at this the whole are of cloud and service providers, it's a very crowded space. And I'm just looking at your wanted margin position in 2020, and wondering is it realistic to expect a new area like cloud to yield those kind of margins, given that there are lot of large, established companies right now struggling to turn a profit in that space? Thanks.
Thanks for the question. Yes, I think that it is going to be a long answer. But sport has been extremely important in my whole life, since I was a child. And that's my spare time life, that I work with sports. I have been the Chairman of the Swedish Handball Federation for eight years, and that job is probably even bigger than being the Chairman of the Swedish Olympic Committee. So that's my spare time job. It will not impact at all on my work. I have no other board assignments, not in any public boards or anything. So I think that's also healthy for someone like me, to develop myself, and work with other type of things, but it will not impact Ericsson at all.
Okay. On your second question
And I will leave the Swedish Handball Federation, by the way of course.
And now, why don't you take the gross margin question?
Yes, we will go from the Swedish Olympic committee to that, to the cloud. So, no, I think that again, very super relevant question, of course, Richard. I think our strategy remains to be the preferred partner towards telecom operators. In there, we focus very much on OSS, BSS which is now part of what you will see then being the cloud and IT product business unit. And we continue to drive utilization as a disruption, and also to build relevancy in systems around the next generation management systems, starting from 5G. That is our main strategy here, and as such, I think we are -- it is possible for us to differentiate ourselves and be relevant, which is in the end going to determine whether we can make good margins out of this or not.
I guess, the follow up is this, don't you see this cloud area has really a race to the bottom, in terms of lowest cost? And is Ericsson historically in a good position to lead that race?
I think that, we, first of all, we probably need to define a little better the cloud, because they are both different. Remember now, the telecom worlds are now virtualizing, We call that cloud in our case, and that has not even started. I mean, on the public cloud point of view there, of course, we have a race to the bottom. But for virtualized products, it won't impact our core, to virtualize products like IMS, virtualize the TV and media solution, or virtualize revenue manager. That's of course -- that's of course what we are doing in this space. And of course, that is coming into our area. So that is basically what we are doing today.
If you talk about cloud, it's very much more talk about virtualization, it's much more talked about for the clouds for telecoms. And then, of course, in this area we have the OSS, BSS as well, which we're created a very strong position in already. I'm not sure if that's clarifying.
No, I get it. Okay, thank you.
So we are not planning to go into public or private clouds and compete there with something. Just to be clear with that.
Unidentified Company Representative
Operator, next question, please? Hello? Operator, we are ready for next question.
Sorry, our next question comes from Edward Snyder of Charter Equity Research, go ahead, your line is open.
Jan, when do you expect the higher capitalization of R&D to become a head wind to your margins when it increases amortization costs?
And then, Hans, the restructuring program seems to be targeted both at cost and efficiency, as well as growth. Is the growth portion more share gains, or do you expect TAM expansion from new products, and do you think you could possibly get to single-digit growth in any of the next couple of years? Thanks.
Okay. The first answer to your question, we have had quite a big [nat] meaning that capitalization and amortization has been quite -- a big difference between those two items, since basically the second quarter of last year, up until Q1. I think during the course of the year, you will start to see these numbers normalize. And if exactly, that it is going to take place in second quarter or third quarter, it depends on the general availability dates of the software, because that is when we start the amortization.
On the growth then, of course, remember there are two reasons. One of course, is efficiency. But if you talk about the growth, I think it's more the TAM expansion. Remember that OSS, BSS and those areas have a higher growth rates than the our traditional core areas. And remember, last year we showed that our targeted areas grew 20%, which is a combination of our software areas, product areas, and our service area. So, of course, partly it is actually that the [legalization] is happening. Media is more important for our customers, OSS, BSS is more important, the virtualization is happening. That means those TAMs are expanding, and I think that's the main reason for it.
We know what -- we have talked about networks. That has a lower growth rate in the market. All in all, of course, the US dollar, as well as given what is happening with the macroeconomics situation. But that's -- so that's where we can see we are well-positioned in the targeted areas, and they have a higher growth rate. And that's why are also partly why we have chosen them, were chosen for our adjacency, but also that they have a higher growth rate, higher deal [software services] and recurrency.
And then on the restructuring program, it sounds like you're expanding significantly the responsibly, giving [eight] new VPs for other folks to take, and responsibility for some of the P&L decisions in the market. Do you think that would prevent things that you just saw, like the global services decline?
And in that area, this was -- is a surprise? Was it like an order cancellation, or did you see contracts didn't play out the way you expected. I'm just trying to get a feel for why the big dislocation and how it caught you by surprise through the quarter? Is it one region? Is it multiple regions? Can you give us a little bit more color on that would be helpful? Thanks.
I think, first of all, our gained the scaling global services that we now can actually allocate and give larger responsibility for certain service flows much higher up in the hierarchy. Which means yet, you can actually take actions much quickly if you see something global based on what is happening and that is part of what we are sort of put into the structure.
When it comes to network rollout, I think as Jan said, of course, there, we knew that there were certain regions that were coming down in deployment. But it also went a little bit faster in some areas than we anticipated. On top of that, of course, then adjustments is taking different times, in different countries due to laws and regulations. So I think that is the combination on that but we are addressing it right now immediately.
And then on your point, around the new structure and how will this issue with volatility mainly in mobile broadband projects, right? So it's, I mean, these projects are in-country specific customers, a customer rollout could take nine months, one year, and then they take lower pace for a year, and then they start again and so forth. How do you staff those projects from a services point of view, in an optimum way? I mean, our way of doing that is of course, that we use to the extent we can, subcontractors and consultants, especially where we have not so much big businesses. So if you have more customers, you can share amongst more customers the resources. Typically, we always make sure we have the senior project leaders and solution architects and so forth in-house. The way we intend to improve or reduce this volatility in terms of the situation we had now in Q1, which we also by the way, had in Q1 2014, but then it was left America if we all remember.
I think, we all go and make sure that we have a better plan, end to end. And that's also, why Hans said that they had network services, we loaned the resources further out to customer, so we will take more risk on the global level. Still, I mean, this will continue from time to time to be a challenge for us, but it's something we have to learn, and also improve all the time.
Okay, thanks, Ed. We're open for the next question, operator?
Thank you. Next question comes from Simon Leopold of Raymond James. Go ahead.
Thank you very much. I wanted to ask two things. One is sort of a relatively simple, and the second is more thematic. On the simple side, just wondering in terms of your expectations for patterns through the year for seasonality if you're expecting more of a backend load than typical seasonality in the course of calendar 2016?
And in terms of thematic aspect, I'm wondering how much of the challenge in Europe may be related to the industry structure of your customers? Looking at some of the statistics, it looks like in Europe, you've got 19 operators controlling 90% of the lines versus China with almost 100% among three in the U.S., and 90% of lines among four. And I have been reading a lot more about the M&A challenges among operators in Europe. Does this create some challenges for you, in terms of weaker customers, and uncertainty about their prospects of consolidating and becoming scale buyers? Thank you.
I thought with the second question, I mean, you're on to something, of course. Strong customers being able to invest and continue to do things, of course, and if you have five operators in a country like Sweden with 9 million people or 10 million people of course, they will have a tougher time, compared to what the sizes of operators you're talking about. So there's a certain extent of that and that's why we see some attempts for inter-country consolidations to get that scale for many of our customers. So what does that mean for us? I mean usually it is, of course, then a tougher environment because our customer has a tougher environment. I think that's how it works. Where it will go, it's a little bit too early to say, but clearly we see the trends that they want to do inter-country consolidation and even industry overall chain consolidation in order to get strength. But that's still to be seen. Some has already been done, as we know.
On the seasonality of patents, it's Jan here. I think the way to think about both Q4 of last year and Q1 of this year, is that we had some extra boost in revenue for different reasons. In Q4, it was obviously the [indiscernible] agreement and in Q1, it was two other agreements signed. I think going forward for the rest of this year we are back a little bit more to normal and I think normal is a good way to think about 2014 volumes. And you had asked that for FX. Most of the revenues is in U.S. dollars so that would be how I look at seasonality for patents, at least with the visibility I have right now.
Okay, Simon, are you happy with that?
Yes. Thank you very much.
Thank you, Simon. Next question please, operator?
Thank you. Our next question comes from Francois Meunier of Morgan Stanley. Go ahead, your line is open.
Thanks. Yes, a quick question, because I'm a bit confused with the new organizational plan. I think you had five sub sectors where you where planning to grow the business, while the rest is kind of declining. I think you had the IP routing, OSS, BSS, TV stuff, these types of things, and I think I forgot about what the fifth one was. But where are those going, and are you expecting still growth from those, is the first question? The second one, very quickly services margins. You answered already, but what I wanted to know is the shape of the recovery? Is it going to be a quick fix, or the beginning of a long journey?
Okay. On the first one, no we you are right in the report, these target areas and you were absolutely right. The one you missed was TV and media. You can say that they had the worst of good growth in the first quarter, not equally good as the last year 20%. But we see still the momentum in them, and they are important of course, impact of some of the emerging markets but we still believe that they have higher potential of growing. Importantly, how we now define the structure of the company, and it's really to show they're sort of the IT cloud, which is always SB cloud, SMB cloud and applications there. And then of course, media is media. And then in the society, it's a separate line to our customers. So we are sort of bringing them out in that. In IP, we of course have our partnership with Cisco that we will continue to report on.
Okay, on the question around services then, Francois. If we take network out to start with, our I mean, intent is not to let this take many quarters. We know that last time we had this, it took us many quarters to get back from a network rollout point of view. We have already started late Q4, and during Q1 with activities. Our intention is to fix this as soon as possible. I cannot guarantee that we will be back on breakeven on network rollout already in Q2, but I mean we are driving it as fast as we can. On the professional services side, the system integration piece there. I mean, it's going to, it's not a cost reduction exercise. It's more the learning curve, having the right people and so forth. So it's not going to be a fix over a quarter. It's going to hopefully be gradual improvements over a couple of quarters, and at the end of the day of course this is also going to come with some growth, right? So it's a little bit different, the profile of the two challenges we have in services, based on Q1 performance.
Okay. So, I know there will be a media basically?
Well, I think that's I don't know if that was the question. I think services, we are not happy with the performance in Q1. We are starting, executing the things we have said. And I agree with you, it's going to be at least the start of this year, that is going to be more challenging than last year.
All right. Thank you very much.
Thank you, Francois. Next question, please operator?
Thank you. Our next question comes from Garrett Jenkins of UBS. Go ahead, sir. Your line is open.
Hi, just a quick one on networks margins. I think, if you adjust for the one off items in [Indiscernible] it looks like network margins dipped below 10%, which I know is your medium term aim. Do you think you can get your network margins back above 10% in this year? Or is that just sort of medium term aim? And secondly, just wondered if there's been any incremental costs associated with Cisco within services, that has maybe weighed the service portions down? Thank you.
No, there are no, on the service side, there's no additional costs in services that weigh from Cisco. Of course, we are building up resources and preparing for solutions we're doing with Cisco, but that's the normal business practice.
I think, on your question around one offs and so forth, I mean, the patent business, I agree that we had support by great patent business in Q1 as well. That is part of the business, as you know, Garrett. I think the, if you look at the overall underlying then, the networks performance, we have a business mix that is in Q1 more of coverage products and hardware centric, similar as Q4. I think that at least short term that, that it will be the business mix we operate with.
And I have also said, that I want you to think about the volume aspect in Q2, considering the currency and so forth. But for sure, we are addressing the cost base, both in terms of the cost of the product, as well as service delivery and so forth. So the absolute ambition, that is that we are going to work hard to be at the 10% underlying operating margin. We have the situation in the market we have, and we have the programs we have. We are addressing costs and we are trying to stimulate more capacity. But right now, we have the market we have.
Okay, guys. We are open now, operator, for the last question for this session, so please?
Thank you, our final question comes from Kai Korschelt from Bank of America Merrill Lynch. Please ask your question.
Hi, gentlemen. Thank you. I just [now had a slightly bigger picture] question on the [SEK9 billion] program. So at least for this year, it seems the gross margin is now, something like 200 or 300 basis points lower compared to 2014, which I believe is your base year.
So I guess, to deliver [SEK9 billion] EBIT improvement, you need to take out another [SEK6 billion] or [SEK7 billion], compared to just three months ago, right? Just because the gross margin is that much lower? I'm just wondering, are you prepared to do this? It seems like a very high incremental step. If you are then, when are we going to see, I guess, the announcements, or the evidence of this? Thank you.
Okay, Kia, it's Jan. Thank you for the question. So first and foremost, when we make the statement we do around the net savings plan, [SEK9 billion], and we are executing towards that, and that's our ambition. When it comes down to the other question raised around gross margin, of course, if we will end up 2017 with a significantly different business mix and so forth, then we will have to obviously talk about that when that happens. So far, we think it's too early to speculate around business mix for 2017. We will continue to execute on the things that we can do, without putting any business at risk, but still improving efficiency and so forth. And you see, we will continue to make announcements. But we have this principle of making those announcements to the one's concerned first. And we will continue to do that, Kai.
Okay, Much appreciated.
Thank you, Kai. And maybe Hans, the closing remarks?
No, I think that you have asked a lot of questions. We are in the first quarter. It is, of course, a mixed quarter with some positives, but also some challenges. I think we are taking actions. I think we have a great portfolio, and a great solutions, but then services portfolio, and it's for us now to put the structure in place, and we will do that from the first of June, and that should help us in this -- July, 1st of July. I say June all the time. It's not the Freudian slip, it's 1st of July, And in order execute on our strategy and accelerate that, in order to address both the market's perspective and the business perspective, but also our financial performance that we want to improve. I think that we are feeling very energized. We have a new team coming into place here, with a lot of great experience and people.
So we are excited. Of course, it's a challenging time, but we are taking everything we can control, and we will do that well and fast.
Okay, thank you.
Thank you. Good bye.
Thank you. This now concludes the conference. Thank you all very much for attending. You may now disconnect.
Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.
THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.
If you have any additional questions about our online transcripts, please contact us at: firstname.lastname@example.org. Thank you!