Telefonaktiebolaget LM Ericsson (NASDAQ:ERIC)
Q2 2016 Results Earnings Conference Call
July 19, 2016 08:00 AM ET
Peter Nyquist - VP and Head, IR
Hans Vestberg - President and CEO
Jan Frykhammar - CFO
Alex Duval - Goldman Sachs
Sandeep Deshpande - JP Morgan
Achal Sultania - Credit Suisse
Simon Leopold - Raymond James
Gareth Jenkins - UBS
Andrew Gardiner - Barclays
Richard Kramer - Arete Research
Johannes Schaller - Deutsche Bank
Douglas Smith - Agency Partners
Welcome to the Ericsson Analyst and Media Conference Call for the Second Quarter Report. To view visual aide for this call, please log on to www.ericsson.com /press or www.ericsson.com/investors. [Operator Instructions] As a reminder, replay will be available on one hour after today’s conference. Peter Nyquist will now open the call.
Thank you, and good afternoon everyone and welcome to this call today. With me here today I have Hans Vestberg, our President and CEO; Jan Frykhammar, our CFO; and Helena Norrman, our Head of Marketing & Communications.
During the call today, we will be making forward-looking statements. These statements are based on our current expectations and certain planning assumptions which are subject to risks and uncertainties. The actual results may differ materially 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 handover to you Vans.
Thank you, Peter. Second quarter was a tough quarter. We saw the same negative industry trends that we saw at the end of 2015 and also in the first quarter where markets with the macroeconomic challenges, currency devaluation, those countries continued to have challenges and we saw that to be intensified in the second quarter. You can look that and see in networks business where in the first quarter basically was flat in constant currency in sales and this quarter was down 11. The same markets that were talked about before, it shows that after several quarters of weak markets, our customers are reducing the mobile broadband investments in these countries.
At the same time, in the quarter, we saw that services that had a very weak first quarter and we discussed a lot about it, had a recovery; they improved in many bottom, top-line but also on profitability; I will come back to that. When we now look out in the second half of this year, we believe these current sales trends and the business mix that we are now seeing here in the first quarter, we expect that to prevail in the second quarter of 2016. We don’t think that this second part of 2016, we don’t think that that will revert in countries like Russia, Brazil et cetera, Middle East which have had a tough time; we don’t think that they very quickly in short-term will recover. That means also that our cost program becomes even more important. We are on the program of the SEK 9 billion that we announced at the end of 2014; half of it going to OpEx and half of it to cost of sales. That program is tracking well. But, we’re also now initiating extensive and significant new cost reductions, given the scenario, both in order to cater for lower volumes but more important to see that we can improve -- continuously improve on our profitability. I will come back to that.
Sales in the quarter down 7% in constant currency, SEK 54 billion, and operating income of SEK 3.8 billion including SEK 1 billion -- or excluding SEK 1 billion in restructuring, which means that the operating income including restructuring was 2.8; so, declined sequentially, which we’ll comeback to, but also of course declined year-over-year, mainly driven of a much lower sales volume.
If you look in to the sales first, you can see that we now have 10 out of 11 regions coming down. Very clear that we have Southeast Asia continuing to the path of 3G to 4G and growing 8%. And then, the regions that we already saw the challenge like Middle East, part of Europe, Latin America continue them to have a challenge to grow the business right now. And it’s mainly mobile broadband, meaning the infrastructure and the services that is coming down.
We can cut this a little bit different. We can look at these countries that I talked about that are a little bit more challenged from both, macroeconomics, oil prices coming down, devaluation, many of the countries remember, the mobile infrastructure equipment, we sell in hard currencies of course, their purchasing power coming down after a while even though they might spend equally much in rubles, they cannot spend equally much in dollar, because that would be a doubling in ruble. So of course, this is now impacting -- and actually the biggest impact to have in the quarter when comes to decline year-over-year; the second is currency, SEK 2.3 billion in currency of course; we have now a headwind, still not a tailwind. EU countries slowing down; there are some uncertainties, but also that lower tier, we had some operators and one in particular that was doing large investment in capacity and rollout, that is now -- that customer has stopped doing that and they are more in capacity mood.
North America, infrastructure is stable, as we’ve seen now in several quarters. However, the service business has been a little bit on decline here. The main reason is that last year we had in 2015 Q2 really good quarter. What we now see also on top of that is that CDMA is now end of life, which means that this related services is coming down very quickly, which of course has been still part of the North American market.
China continued its stable pace on 4G deployment; 2G and 3G declining somewhat, but 4G definitely continue. And then Southeast Asia, as I talked about is positive. So, that’s a little bit to look at it differently. So, there are basically no new markets that are declining. We’re seeing that this intensifying they’re reduction on mobile broadband investment in these countries after five, six quarters that of course had these challenges; they didn’t come right now. But for our customers, this is now meaning that they’re reducing their investment spending.
If we then look into the segments, networks down 11% in currency adjusted compared to basically flat in the first quarter. That of course is impacting the profitability, year-over-year, coming down quite a lot, mainly driven by the lower sales, but also that we have higher coverage at the moment, meaning more hardware. We also had some revaluation of the hedge, which is a forward-looking of course, that was negative. What is positive is of course the cost reduction that we certainly initiated end of 2014, is helping us on mitigating some of those declines.
Global services, from a weak first quarter quite significant improvement, basically from SEK 0.6 billion in profit to SEK 1.5 billion in profit, similar profitability levels as Q2 last year. We see sales down 7% and in currency adjusted 3% down. So clearly less impact here right now, even though the network rollouts are more connected to our products.
On the margin side, we are now double-digit on professional services again, 10% excluding restructuring and network rollout almost zero, minus 2. So, here we’ve of course done a lot rightsizing, as we discussed already in the first quarter. We started in the first quarter; now, we have done it in the second quarter. In total, some 4,000 employees left us in the second quarter, the majority from service delivery.
Support solutions, down 7%, clearly down from the first quarter. Both here support solutions and networks also have impact of lower patents sequentially. Here we basically see a low -- that we have a lower OSS and BSS sales; they came in chunks when we take new deals and becoming software. On the other hand, we see the service side still growing due to OSS, BSS deal because of system integration is something you need to constantly do. We have good traction of portfolio. We signed a very important deal in the quarter with a transformational 12 markets with Vimpelcom, amounted to more than U.S. $1 billion, which is of course a split between system integration and software. So, we see a good traction of portfolio, but actually no real improvement on top line on software -- on support solutions, which is impacting the bottom line here, both with lower patents but also that we had lower software sales here.
That leads me to talk about additional cost reduction we are doing. The SEK 9 billion, as I just want to come back to it again, the 9 billion was 4.5-4.5; 4.5 on cost of sales and 4.5 on OpEx. What we are now doing, we are basically doubling the reduction on OpEx for the same timeframe or the second half of 2017 run rate to reduce the double in OpEx. And the main reason is that of course we see a lower volume, but also that again we’ve put a new company structure that was designed to take out cost. We now see that we can do that. There are duplification [ph] in the portfolio. We are doing end to end much better for supply, sourcing service delivery all that is very important. We also are continuing to reduce our IP investments, IP routers on the sort of agreement -- strategic partnership agreement with Cisco, that’s also attributing. So, that’s part of what we’re doing in order to reduce the whole OpEx then with 10 billion. And Jan will come back to that.
We also are intensifying of course the reduction on cost of sales, very, very important because we have both the reduction in volumes here. We just need to do as we have done in the second quarter when it comes to network rollout and the services where that has to be intensified with market condition prevailing, as we are saying. So, that’s also a very important; that’s a big piece of it. And here of course it’s variable on top line but we just need to bring out fixed cost in cost of sales as well.
So, this is what we now are adding to the program with a same time frame as we had before, and Jan will come back to it. So, Jan, please.
Yes, hello everyone. And thank you, Hans. So, if we then start with the operating income, some comments on the operating income. I think before I do that, I just want to say that we have worked with trying to explain the most important parameters of the performance in the quarter. So, I think we have done that in a pretty good way, enabling better accuracy on the consensus line for Q2, still some more work to be done there. And I think what we are trying to do here today is to be a bit more precise on planning assumptions. We know that that’s -- I mean in terms of perception it’s important to be on or even perhaps slightly better than consensus. So, this is an important thing for us and we have spent a lot of time on this during the quarter. Many of you are aware of that.
If we then look at the operating income, you can say compared to year ago, we managed to offset the sales volume decline with reductions in operating expenses. That’s the short story of those two items. We had an impact on the income because of lower gross margin. As you can see on this picture, that had to do with more hardware and more coverage projects, I mean Hans mentioned the Southeast Asia ones and so forth; and that was something that started already towards the end of 2015. But in this comparison, we had a lower -- or a high share of hardware in the mix. Also we had slightly higher services share compared to one year ago. So, you can say sales volume decline and OpEx offsetting each other, what impacted the underlying income was the gross margin decline.
The hedge impact there, that’s more future oriented, as you know. And here, the impact is mainly to look at the closing rate, mainly for U.S. dollars compared to the starting of the quarter. And in this particular case, it’s obviously one year ago.
If we take gross margin sequentially, that was also important for us in the quarter. You see, we had the IPR revenue, which we have decided now in this quarter to disclose. So, we disclosed Q1 of 3.8 billion and Q2 performance of 2.2. That’s a big impact obviously on gross margin when we compare Q1 performance. And then, we had an increasing share of services in the business of 1 percentage point. And we are still basically on this rule of thumb that if you increase services shares with 1 percentage point, it gives around 0.3 percentage point impact on group gross margin in both directions. And I think that’s the rule of thumb that still holds. Then, we had the underlying improvement in the services business and that was both related to professional services as well as network rollout in the quarter.
Coming to cost savings on service, I mentioned a lot on this already. What I wanted to show with this slide is of course that if you take the operating expense, it’s down compared to a year ago with SEK 2.1 billion excluding restructuring charges. In the order of magnitude, the 3 things there that -- they are all the three things, savings related to the cost and efficiency program; reduced amortization of intangible assets; as well as increased capitalization of development expenses. They’re all there; they are in the order of magnitude. And you can say that approximately two-third of the reduction is related to the cost and efficiency program, which is important.
Restructuring charges for the year will remain with the guidance we gave in April for this year. We will comeback with guidance for ‘17 as soon as we can guide for that, depending on the discussions that we now will initiate with trade unions and so forth. But at the latest, we will do that at the Capital Market Day, but hopefully a bit earlier.
The cost of sales reductions, Hans has mentioned; the only thing that I want to add to that is of course that we are trying with the new organization to become more effective in end-to-end cost efficiency, for instances mobile broadband. That’s important for competitiveness; that goes also with the implementation of the new Ericsson Radio System. But it’s not only the TCO on the hardware; it’s also how we work with the services attached to that product. And it’s obviously an important theme that we have in the company now for second half of this year and going into next year.
If you look at the picture there, you see the OpEx in a full year perspective; so, I’ve taken for instance the June numbers and the last four quarters. So, it keeps this feeling for the annual run rate of operating expense. You see that the other item there that consists of the net of amortization of intangible assets as well as capitalized R&D. Now, in the June numbers for this year, it’s very limited, [ph] will now start to depreciate on the capitalize R&D. As I’ve said many times, the products are now coming gradually into general availability; and once that’s been accomplished, we will depreciate during 36 months or three years. So, we should expect that other item as you can see in the slide there is becoming also cost item. So, the underlying expense level is really around 50 billion, which then is a doubling, as Hans mentioned.
If we then take a look at the cash flow, of course this quarter was impacted by the dividend payments. We had an operating cash flow of SEK 700 million negative, that’s -- the impact is -- if I exclude some extra tax payments as well as some buffer stock on mobile broadband, and since the radio volumes came down in the quarter, we ended up with a slightly higher buffer stock than what we typically had. That’s only a timing issue and that will be consumed during second half of the year, but also are important things to remember. And here, I want as always you to judge our performance on a full year basis. And finally, it’s good to know that the CapEx for the ICT centers have now peaked.
Looking at currency exposure, still the U.S. dollar is the most important currency, and that’s the case also in this quarter. You see there the development of the P&L rates and also altogether the closing rates disclosed on a monthly basis at the IR webpage. So, that’s important.
If we look at the planning assumptions then; and this is just the summary of statements that we have made in the quarter report. So, I think the most important one here is obviously that the current sales trends and business mix that we have been having for Q2 will prevail for second half of 2016. We have talked about the OpEx run rate; and that’s then going to be reduced to SEK 53 billion excluding restructuring charges and that is from first of July 2017; so, it could be a gradual decline there during the course of the period. The restructuring, we have already mentioned. The IPR licensing revenue in the quarter was SEK 2.2 billion and that’s representing the current IPR licensing portfolio. And then, you have the FX rates, and I’ve already mentioned that. And all of this is of course based on current assessments and visibility. And if there will be major changes here, of course, we will inform you about those things.
With that, Hans, I hand back to you.
Thank you, Jan. So, we talked a lot about the quarter and what actions we are now taking to improve the profitability and also that I mentioned the Company for the lower volumes, which is extremely important that’s well said before and said before, we’re not satisfied with the profitability of the Company. And that also go for being competitive in the market we need to have a lower cost base; and that is we’re now taking next step on.
We’re kind of also looking a little bit broadly on the continued strategic execution and talk about a couple of things we’ve mentioned before. Number one, of course leverage the installed base in our core business, enormously important for us; that’s both the technology and service leadership. We have now put a structure in place, network structure that is going much more end to end. Here, we believe we can both take out cost be more efficient and definitely deliver even better to our customers on their requirements. That’s part of the new corporate structure that we put in place on the 1st of July. And of course we’re going to have combined functions here between the networks products and network services when they work together all the way out, and we have also moved responsibilities for service deliveries and supply further back in the chain in order to take quick correction. And then, that’s of course part of what we talk about the increased cost reductions, but it’s also a way to work much more like our customers are changing right now, having these as joint of working with much more responsibility.
That also goes for the next year what we call the target areas before, which is basically now structuring the Company; they are IT and cloud of course which consist of the virtualization and the cloud as well as OSS, BSS. That together with the system integration of course is combined in a couple of the most important target areas. Here, we need to continue to have the growth of course; at the same time, these should now going forward be accretive to bottom-line, start adding because we’ve been in investment for a while. There we also set the structure that’s going to be able to work on that end to end much more efficient. In the quarter, the so called target areas grew 5% in constant currency and they stand for roughly 20% of our turnover. So, even though they are not up to 10% that we believe the market can be, we believe of course there is a contraction also there but we are still growing in it and it’s an important area.
We also have of course increased investment in 5G, because that’s coming earlier. And I can tell we have really good traction on the virtualization, 5G and digitalization service that we have, and a lot of customers of course very interesting. And we do this with relevance. At the same time of course we are opening up the channel for investment [ph] society and for media where we’re going to be more sort of sensitive to which markets we’re going to; we’re not going to do that across the board as we’re doing on networks and IT and cloud because that’s we’re addressing all markets in the world, 180 in the society and media, they would be much more focused on the markets where they believe they have the greater chance in the beginning, right now Rotterdam exploring the whole world. This is all part of being more efficient as well.
And then, on the IT and cloud, they’re duplifications [ph] there like in the OSS that we work with. We also mentioned in the report that the IP investments will go down even further given that we have a strategic partnership with Cisco; so, all that is also part of how we put up the Company structure. And ultimately, as Jan said, very important to generate strong cash flow, both in order to have strong shareholder return but also being able to do the long-term investment. Here we are continuing working capital to continue to reduce that, and also going to the mix of more software and service over time as well as Jan said, we’re peaked on our global centers, CapEx investments. So, this is important to all of them in order to cater for that strong cash flow generation. And as said, measure on us [ph] full year when it comes to cash conversion; we have been above 70% which is a target for the last six out of the seven years. And we are always aiming for that and that is no different for this year.
All-in-all, summarizing, tough second quarter, the negative industry trends intensified in the second quarter compared to the first quarter but basically the same impact in mainly mobile broadband investment in certain markets. That’s what we had. We had good progress in services, which we already announced in the first quarter. We had to take out cost very quickly and that we did and especially on the network rollout. On the system integration, we explained that that will gradually take time to improve, and that’s very much driven that we have a lot of new digitalization projects in the start-up phase, which is growing much more resources and cost in the beginning in order to get into the milestones and later on to the upsell. That is seeing that we have more proportion of deals at the beginning, and that’s where some of them we have announced and we’re working with of course very, very important deals because this is sort of our enablers for getting into these areas which we’re now investing in. So that’s all in good but it will take some time gradual time that system integration will recover there, even though we saw a recovery in the quarter on professional services.
And in light of these market developments, as you Jan and I stated, we are now increasing quite considerably our cost effort. On OpEx, we’re pretty clear that it is doubling; we of course need to do a lot on cost on sales as well, both on the fixed cost of sales but also on the variable as the volumes come down in certain markets. Already in the second quarter, we had already started with that, so that journey will just continue and increase in the next four quarters to get to the run rates and profitability we want to have going forward. Thank you very much.
And I think also one more comment, Hans. We have Sunday evening European time -- we had an article in a Swedish newspaper called Svenska Dagbladet that was commenting in a wrong way some of the claiming that Ericsson had made the incorrect accounting of uncertain items and that was something that really made both Hans and myself very upset. We have then consequently on the IR web page of the Company now posted a comment on that article. I know that some of you -- that’s not lead Swedish media but that was something that was very important for Hans and me to clearly make a statement. That article had many faults in it and it was incorrect and that’s -- it’s now posted on the Company’s IR web page, just as a final remark for me.
Thank you, Jan and Hans. Operator, we are now ready for the Q&A. So, you can open that session please.
Thank you very much. Ladies and gentlemen, at this time we will begin the question-and-answer session. [Operator Instructions] So, we have our first question from Alex Duval from Goldman Sachs. Please go ahead.
Just to clarify firstly, you talked about the worsening conditions in the second quarter sequentially. But just want to understand, of that lower base you’re now at, is it fair to assume normal seasonality into the third and fourth quarter of the year or should we be thinking about something sub-seasonal? Just to clarify that. And secondly, if I look on gross margins, these would have been significantly impacted sequentially by the 1.6 billion lower revenues you called out on the slides. So, given that gross margins are roughly in line with expectations today, the underlying gross margin was perhaps better than people thought. Clearly, you have taken significant actions on the services piece, but just to understand gross margin fully, can you talk about what kind of price competition you’re seeing right now in the market?
Okay. So, when it comes to the trends being worsening, as we clearly talk about in the second quarter here, I mean, we were also when we went into the second quarter, we were telling you that we had you can say the emerging market bucket of countries there that Hans mentioned that had typically a quite strong seasonality between Q1 and Q2, that was not going to show that seasonality and I think that was captured well by all of you. I think the situation on those markets is still that we have a challenging situation; there will be still see some seasonality of course between different quarters. But I think for the modeling purposes, we say that the industry trends that we have right now in this quarter will prevail. And we are in this moment -- we have a situation this year where it is more uncertain on top line, but I think that we will of course have some seasonality. And typically it’s not that big of a difference between Q2 and Q3. But, I think if you look at the markets, it’s those emerging markets but it’s also slow business volume in Europe. And then, finally, I think it’s also important to remember what we said around the IPR revenue there.
On the price competition that you brought up, and of course it’s a tight market but you can also see that’s little bit less on investment, now we specifically talk about mobile broadband because that’s usually the question you are posting when it comes to price competition. There are fewer deals out in the market at the moment because as many regions right now on a low intensity of deals, of course less deals to talk about, but the ones that are out there are of course new deals or swap out that are fewer, they are still competitive as they’ve been all the time before. So that’s no difference of course; it’s a little bit less of a deal coming up. You get little bit more inflective on the ones that you know about and then may be being able to draw a line between if it’s more competitive or not. But clearly, it’s competitive on the new ones. And that’s also part of why we continue our journey on cost efficiency here. And of course on the radio side, we’re much looking forward to Ericsson Radio System that we will launch at the latter part of this year and starting substituting which is great reception in the market and very important one.
Thank you very much. Next question is from Sandeep Deshpande from JP Morgan. Please go ahead.
My question is regarding your working capital. I mean the revenue of the Company has come down again in the quarter but your working capital has increased. You’ve explained some factors, Jan; maybe you can explain how you expect the working capital or rather the cash to grow to the rest of the year and in a period where your revenues are under pressure why your working capital is continuing to be under pressure?
Of course, I mean first and foremost -- there are a couple of aspects to this of course. Last year, if some of you remember, we had quite significant build up of working capital, mainly driven by Mainland China 4G deployments. And that started, if you remember, already in the end of 2014 and went through 2015. And then we managed to get the contracts, signatures and the cash collection in Q2 more as a catch up. Now, this year, we are back to more of the normal, I would say normal business profile in China, which means that we are building. And we then count on more of the collections to take place then in the fourth quarter. So that’s one reason. Then, of course the discussion I had around the buffer stock, I mean what we do is of course that we have -- I mean a couple of years ago we had -- three, four years ago, we had some -- you remember we had this Tsunami situations, and since we didn’t have back then a buffer stock on finished goods. We decided to have at least on the key components enough of buffer stock and that we put as a more -- as a relative number to the total volumes that we forecast to ship now; that came down a bit in the quarter, which made the buffer stock go up. That’s about SEK 1 billion; that will be consumed during the second half as we then reduce the production capacity. That’s one aspect.
Other than that, I mean the working capital build up is -- I mean even though of course top-line designs, we should release working capital over time but the most important factor for us still in terms of working capital when we are dealing with mobile broadband is the mix, and that continues to be the mix. I mean when we have countries such as Indonesia, Bangladesh, Mainland China and so forth in the mix, we have project terms in those markets, which means that we invoice based on the preliminary acceptance and clusters rather than on state contract terms. So to define the working capital going forward, it’s more important on the business mix.
Having said all of this, I also made a clear statement, Sandeep, that of course in a negative revenue scenario that should mean a lighter balance sheet. And I agree to that, it’s just that it takes some time.
Thank you very much. Next question is from Achal Sultania from Credit Suisse. Please go ahead.
One question on the OpEx guidance; so, obviously now the guidance is of 53 billion base by end of -- by second half of ‘17. I think when you had old guidance; obviously you were expecting some kind of growth in all your key markets. But, given what we are seeing now, is it fair to assume that once we get the 53 billion of OpEx, is it enough to get to 10% plus EBIT margins across all your three businesses by 2018? And does that 10% margin imply that you expect sales to start to grow in 2018 or at least stabilize from in 2018?
I think that the cuts that we are doing right now is aiming what you are saying, we have a little bit of different expectation on different units. But again, it’s clearly to improve our profitability. That ambition is definitely into that 53; and with the current visibility we have on volumes, we think that’s clearly enough. As Jan said, if something changes, we will do more. But right now, this is really what you are saying. We are not planning at least in the short-term for an increase in volumes, as we’re clear on that. That we believe is going to be a decrease I would say, or keeping sort of the same fundamentals in mobile broadband. So, we are vesting that the structure that we are putting in place, the organizational structure and the cost structure we are doing, that should improve our profitability and also manage the downsizing in certain markets where we have lower volumes. So, yes, you are right, we’re aiming for protecting a higher profitability; that’s part of what we are doing.
Thank you very much. Next question is from Simon Leopold from Raymond James. Please go ahead.
I wanted to get a little bit of clarification on how to think about the new cost reduction, because I am considering the way many analysts build models, as well as seasonality and the fact you’ve guided the second half of 2017 where we normally would expect seasonality leading to higher expenses. So, I’m just worried that we might make some erroneous assumptions in terms of how we build in this new reduction. Would you expect that 2017 would lack half seasonal patterns in your operating expenses because of the reduction efforts? And also do you expect a greater proportion of reduction in SG&A versus R&D, given what you talked about in terms of depreciation on the capitalized investment?
So, my point would be that the 53 is an all-inclusive number excluding restructuring, to start with, right. And what we were trying to highlight in that picture there, Simon, is the kind of underlying element. And of course what we are working on is real cost savings, meaning underlying expenses, to be clear. The way I want you to think about the guidance then on 53 is that that run rate is going to be achieved 1st of July of 2017. So that’s the first time that you will be able to see, to inspect that number in reality obviously end of June in ‘18, right. But that’s what I want you to guide on. We will report on a quarterly basis going forward. We will report in the same kind of setup as I have in that PowerPoint slide there. So, it’s all the time look historically four quarters and then report progress on the 53.
And of course, when it comes to this real cost savings, they come a bit in waves because of where we do the reductions that some countries, it is fast; some countries, it takes more time. But let’s take this quarter-by-quarter now and it is clearly our ambition here to do the right things, the structural savings and do them fast and with urgency and then having this run rate being delivered from 1st of July, 2017. I hope that helps.
It does. Thank you.
Thank you very much. Next question from Gareth Jenkins from UBS. Please go ahead.
Just a quick question on potential areas of pruning the portfolio. I understand what you’re saying Hans in terms of the new areas of growth providing accretion to the bottom line going forward. But I’m just wondering, particularly around support solutions whether you need to be in a business, which can move from a profit to a loss, quarter-to-quarter, with what appears from the external community as quite a degree of variability.
I think that first of all, there are pruning to be done, and I mentioned that some of the overlaps in our OSS portfolio, for example that we now will take care of in the new structure. There are probably other areas we’re looking into as well. So yes, they are pruning and we’ll continue to do that. The support solutions, of course, it’s also driving a lot of system integration. As a combination of it, we’re growing on OSS, BSS; that’s important to state that.
So, of course, now we’re not to driving enough software revenues and that of course is something we need to get in, in the current models with our customers as we’re now going into new digitalization. It takes some time to make that movement, but obviously there are pruning to be done, but we still believe that OSS, BSS and new portfolio is extremely important for the market. You might remember we showed how a typical deal will look like when it talks about a transformation where basically 50% is pure services and then maybe a quarter is our own software and then third party software that’s a typical large digitalization transformation. So, it’s a quarter coming from support solutions and 75% from somewhere else. So, one needs to weigh that in, when we look at holistically. In the new structure that’s going to be one unit basically. So, then, we can show that in a much clearer way. Right now, in the current structure that will keep up to the end of the year. We are keeping services separate and software separate. Over time, this is a solution; this is how customer buys it. They don’t buy it separately. They buy -- and that’s a strength that the Ericsson has as well. So, we should see that the one is supporting the other. That doesn’t take away that we look in pruning, things that are performing, we will take out. But initially, if there were overlaps we’re working with, it’s a reduction on IP and a couple of other areas.
Thanks. Can I follow up on that one?
Yes, you can.
Just quickly then, I was just wondering whether you feel support solutions in its current form pre-reorganization kind of reach a sustainable margin one quarter to the next, say about 10% or whatever the number is but a nice sustainable quarter after quarter margin?
Yes, I believe that; and it’s a volume issue because the gross margins are fine; it’s pure software. So, it’s more volume game. We just need to get to higher degree of the recurrent software business in there and that’s where change in the model; that’s what we need to have in there; so, yes.
Thank you very much. Next question is from Andrew Gardiner from Barclays. Please go ahead.
I was just interested in a bit more detail on what you said about the reduction on the IP side of things, just can you perhaps give us an update as to how things have developed with Cisco since the November announcement last year and what -- to what extent is this your reduction enabled by what you are doing with them; what have you had to negotiate with them; what will you be relying on them for in the future; and have you got to a stage where there is some joint product development just to make sure that Ericsson, if it goes to market, isn’t missing out on anything? Thank you.
Thank you. Yes, you are right; I will give you an update. First of all, I mean, I think after the first quarter we talked in Barcelona over couple of deals that were signed together with Cisco, now we have over 30. So, the pace of new deals is coming in, even though they are fairly small at the moment, we are at least seeing it. And that’s the reason that we have now defined all the solutions that we have together that we can go together within 180 countries. So, this is now good traction, good funnel, still a lot to be done here, but we’ve at least started and increased to more than 30 deals compared to a couple that we had when we met in Barcelona. So that’s very important. And that was the main focus in the beginning to honestly to see that we can create more sales for both companies, $1 billion in 2018. So that’s still a target and we are starting off here at least, still a lot to be done.
On the cost side, we already had of course plan to -- we had peaked on our IP investments at the end of 2014 coming into 2015, still growing. So, that was part, if you look at the chart, Jan; we were on an up going trend in IP in beginning of 2015 and then all basically in U.S. dollars as well. So, it didn’t help us much on the OpEx. Now, we have started to decide which products we want to keep and not keep. And of course some of them we will rely on Cisco especially on layer three and layer four. And then we are reducing our R&D in IP and routers. We talked initially on synergies of 1 billion; of course we see potential of doing even more; and that’s part of the reduction right now the doubling of the OpEx reduction. I will not go into more details on the portfolio; we can do it at a separate time when we come back to the partnership. But, clearly, this is part of the strategic choices we’ve done when it comes to our IP strategy.
Next question is from Richard Kramer from Arete Research. Please go ahead.
Guys, I am having a bit of a hard time accepting that explanation about the surprising market developments and challenges in network growth. And it reminds me a bit of when your predecessor, Hans, Carl-Henric Svanberg was surprised by the weaker sales in third quarter 2007. So, what’s happened with the sort of CEO level contact with customers and from your sales force that meant at the start of the year you didn’t have visibility to anticipate this weaker sales effort and maybe make earlier, deeper cost reduction efforts rather than restructuring program that now seems like your -- it was only half way measure. And second question, I have second question for Jan, or maybe you want to take that one first?
I think that I’m not sure that we’re articulating surprise here. We’ve seen an intensification of the decline that we talked about already, at the end of the year that we already started in the beginning of the year of the program. But of course we have seen also clearly that we don’t see that coming back, that is part of it and that’s why we increased our cost efforts. So, obviously, if you look back and come up with brilliant answers but we are taking in it right now and we have done it quite significantly; in the first part of the year we have reduced some 8,000 employees and of course that will now accelerate, given what we’re planning to do. So, we will do that and we are close to our customers and working with them all the time to listen to what they are doing but of course there realities can also change.
And I guess the second one on the same vein, if you look back since you guys sort of stepped in 2010, the share price was actually lower than it is today, and there hasn’t been a sort of incremental equity value created. Are you confident that this latest restructuring plan is going to create sustainable equity value or are we -- should we be anticipating that there will be a 2020 plan once we get into 2017; is that just the nature of the industry that we’re in and an inevitable consequence of the price competition and technology development.
We acknowledge that we’re not happy with the share price development; that’s clear, we’re not happy with that, Jan and I, and not the profitability, neither. So, we’re working hard. And the plan that we’re putting in place, we clearly believe that’s going to create shareholder value and we should be able to increase the profitability but also size the Company for at least in the short to medium-term, lower volumes in mobile broadband.
Next question is from Johannes Schaller from Deutsche Bank. Please go ahead.
When you were talking about the IP R&D cuts and the Cisco partnership, you were referring again to the 1 billion of cost saving you mentioned there, but there must be much more you can take out on the routing side in terms of R&D. So, could you first give us a bit of a feeling, how much of the 4.5 billion incremental is coming from IP that would be helpful? And then secondly, how you’re looking at the Cisco partnership here; how long do you have to retain some of your products at the SSI’s house [ph] and when can you actually discontinue those, given the customer agreements you have in place, and isn’t there much more cost savings potential maybe a bit further out here? And then I have a housekeeping follow-up. Thank you.
Johannes, it’s Jan here. I think we have given you the detail that we want to give on the IP and the Cisco partnership for now. I think a good way to understand the reductions that we have achieved so far is to look at the R&D reductions year-over-year. Remember now that the, from an OpEx point of view at least had an FX headwind last year; we have reduced R&D mainly in the cloud and IP area. And of course going forward, we will continue to optimize the portfolio and create synergies, and that results then in a possibility to increase the OpEx plan. However, the OpEx plan will not only be about R&D reductions going forward, but equally much around R&D reductions as well as sales effectiveness. We need to make sure we have a very competitive R&D machine that’s clear. So that is the way I would like to answer that and will not give you more detail than that for now, Johannes.
Okay. So, I won’t ask another question. But just as a housekeeping item, maybe you could give us a bit more color on this, special tax outflow you had in the quarter, just where exactly that was coming from? And is there anything in there that is recurring or if that is purely a one-off for this quarter, that would be helpful, bit of guidance on cash tax?
No, I think that when you look at the tax -- I mean, first and foremost, Ericsson is operating in 180 countries. And if you look at typically, we have a tax rate in the income statement that has been a little bit on the going up trend, so to say. That has to do with the fact that we have been very successful in the services business, which means that you tax obviously services based on the local profits in each country. You can say, I think to be simplistic, I think that it’s a good way to assume that the tax rates we have in the income statement is also going to be the cash tax rate over time. Now, in this particular quarter, we had some more one-time payments related to some transfer price, settlements or agreement that was a multiyear and it was in two particular countries. I will not comment more than that for that topic, Johannes.
Thank you very much. So, the next and last question is from Douglas Smith of Agency Partners. Please go ahead.
You had some updates on the relationship with Cisco. So, we haven’t heard very much about the global alliance with Amazon Web Services. Since its announcement in February, there seems to have been not much of an update despite AWS growing by leaps and bounds?
Okay. I’ll take that one. When it comes to the whole HDS 8000 deployment, which is the joint sort of work with Intel based on their Rack Scale. As I said, when we launched that in Barcelona, we had a lot of partners that really use that type of services, and of course AWS is one of them. The product is coming out here now. We have some products already out and it’s coming more in the second half. So, I think we can come back to that on the Capital Markets Day a little bit more how that continues. But we feel good about the portfolio; we feel good about HDS 8000, which is not one product, it’s a portfolio of different products that can be both virtualized and non-virtualized. So I think that, and that discussion is ongoing and many interested parties. But it’s just about to start. So, let us come back to update you on that when Anders Lindblad and Jean-Philippe will talk about IT and Cloud at the Capital Markets Day in November because then we can both have the business plan thinking but also portfolio thinking that’s what we have in that portfolio.
Okay, Douglas, you are happy with that. And then, Hans some closing remarks, we are ending the conference call.
Thank you, Peter. No, I think again we are in a market that is changing; Ericsson is changing as well in order to both create stronger portfolio, diversifying portfolio in new areas which we think is so important for Ericsson going forward, also creating new types of customers. We’re putting a structure that supports that that is also designed not only for the customer needs but definitely designed for cost reductions. And that will be utilized right now to be more competitive, safeguard our profitability improvements that we so dearly need, but also thinking about the new type of mix we will have in order to improve and continue to have a strong cash flow. I think that’s what we’re extremely focused on; we have a new management team coming in, very energized, and that we now are working hard with in order to execute on this. They’re only three weeks into it, but I think that this is really going to pay off.
Ladies and gentlemen, this concludes our conference call. Thank you all for attending. You may now disconnect.