LM Ericsson Telephone Company (NASDAQ:ERIC) Q4 2018 Earnings Conference Call January 25, 2019 8:00 AM ET
Börje Ekholm - President & Chief Executive Officer
Carl Mellander - Chief Financial Officer
Peter Nyquist - Vice President & Head of Investor Relations
Conference Call Participants
Edward Snyder - Charter Equity Research
Pierre Ferragu - New Street Research
Simon Leopold - Raymond James
Sandeep Deshpande - JPMorgan
Jorgen Wetterberg - Nordea
Tal Liani - Bank of America
Stefan Slowinski - Exane BNP Paribas
Achal Sultania - Credit Suisse
Richard Kramer - Arete Research
Welcome to the second call for today this afternoon call. And together with me here today, I have our President and CEO, Börje Ekholm; our Chief Financial Officer, Carl Mellander.
So during the call today, we'll be making forward-looking statements. These statements are based on our current expectations and certain planning assumption, which are subject to risk and uncertainties. The actual result may differ materially due to factor mentioned in today's press release as well as in – discussed during this conference call. We encourage you all to read about these risk and uncertainties in our earnings report as well as in our annual report.
With that said, I would like to hand over the word to you Börje. So please Börje.
Thank you, Peter and welcome to our report for the fourth quarter of 2018. And thanks everyone for joining us.
So 2018 was a year that we proved the competitiveness of our focus strategy, so we exited the year as a clearly stronger company. Early in 2017, we launched our new focus strategy where we defined a clear focus on the service provider and solving their problem.
Foundation was technology leadership, product-led solutions, global skill and scale and establishing a cost efficient operation. Over the last 18 months, we have relentlessly executed on this strategy. After 2018, we are now a stronger company with a good and competitive product portfolio that have resulted in a growing top line as well as a more cost efficient company.
With the headwind from a still tough market as well as contract exit, we were able to return to growth on the top line for the first time since 2013 on an FX adjusted basis. And this is all supported by the investments in R&D that has given us a very competitive portfolio. And when you are investing for technology leadership you are also able to get cost leadership and we have seen a expanding gross margin as well.
The cost reductions we have done over the last year and a half has given us a very competitive cost structure and we're now profitable on an operating profit level before restructuring costs.
The market has been tough over the last few years, but we see the momentum coming back to the market with the launch and the technology shift into 5G as well as the growing demand for data. And to intercept that, we have invested and increased our commitment to R&D and technology leadership and we see today that we have a very strong offering.
We feel that we are comfortably on track to reach our target for 2020 of more than 10% of operating income excluding restructuring and for 2022 of more than 12%.
The Board has put together a judgment about our situation, our recent turnaround and that we actually have net income that's negative and proposing an unchanged dividend of SEK1 per share.
For the full year of 2018, we've had positive growth adjusted for FX of small number 1%, but it is the first time since 2013 and it happens despite headwind of exiting businesses.
We have also completed a SEK10 billion program we launched in 2017 that has resulted in expanded gross margins as well as lower SG&A. We have solid performance in earnings in Networks as well as Managed Services. We still have to turn Digital Services around, but losses have been reduced during the year even though we have more to do to really turn it around. We continue our reinvestments in emerging business, but we are now seeing signs that the businesses that we have are scaling well.
Cash flow is positive. More importantly, it's more evenly distributed throughout the year. We have also continued to reduce the sale of accounts receivables. And we can see that the increase in sales at the end of the year has expanded our accounts receivable and thus lowered the free cash flow.
If you look at the fourth quarter, the growth accelerated during the year. So, in the fourth quarter, we grew by 4% and that's driven by Networks and Digital Services. Our focus and commitment is to manage the overall profitability in the company. So, included in the results here are, of course, significant costs for strategic contracts as well as field trials, but there we've been able to absorb them in the numbers we've taken.
We see especially those costs in Networks and it's even better to see that Networks has despite that shown a very resilient P&L with the good profitability.
Managed Services are established now at a different profitability level after completing the review of all the contracts. Managed Services Emerging Business and Other is negatively impacted by losses in Red Bee Media and Ericsson Media Solutions. The remaining part are still loss making, but it's actually starting to scale, so we had a growth of 60% there. This will continue to generate some losses, but we are investing for the long-term value to Ericsson of strengthening our product portfolio long term. The investigation from SEC DOJ continues and we have no news to share, but we are just saying it's ongoing.
Free cash flow was positive, but the increasing accounts receivables was a drag on the numbers. And I wanted to take some more time on Digital Services and make some extra -- maybe deep dive is the right way to say it. Digital Services is strategic to our portfolio with our core OSS and BSS offerings. But we have to remember that this area has been loss making for several years, so this is not a problem that came in 2017 nor did it come in 2017. It's been ongoing several years.
So if you look back actually that in 2017, we didn't have a single product area reaching profitability in Digital Services. So what we did was about a year ago defined a strategy and a plan with that would turn to the business around and reach low single-digit profitability by 2020. We knew at the time that that would take two to three years to fully turn the business around given the problematic starting point.
The strategy in simple terms being to stabilize the top line and establish a competitive cost position, but we have also increased our investments in the 5G core and making sure that the portfolio is cloud-ready or cloud native and ready for micro services. The team-leading and working in Digital Services have made real progress on strategy execution during 2018 and on the turnaround and this includes a large number of wins during the year.
So in the fourth quarter, we were able to turn a small growth of 5% FX adjusted, but nevertheless stabilizing the top line is key in the turnaround. Cost-out has continued and we see improving gross margins, but we also see reductions in operating costs. And during the year the improvement in expenses have been SEK2.6 billion with a higher run rate at the end of the year. So we come out nicely from 2018. And we – more importantly, we now see that we have positive operating income in several segments in the business. But we also have one clear area that's driving the losses and that's BSS within Digital Services.
Here, we made less progress on overall strategy, so we decided to actually reshape the strategy from the past and our focus going forward is to invest and drive our established BSS platform Ericsson Digital BSS. Here, we have a large installed base with more than 350 customers worldwide and it is a sound business that we have. What we do now, we increased our investments in Ericsson Digital BSS, because we see that as of past that our customers can migrate to a future architecture and future product in order to monetize 5G and IoT opportunities. This also means that we are refocusing revenue manager on fulfilling existing obligations as well as leverage the components from revenue manager in our Digital BSS platform.
In order to execute this strategy, we have – it will be associated with costs. And we have taken costs of SEK6 billion in 2018 and we will take about SEK1.5 billion in 2019. These costs are related to mostly to changing the scope in our contract, but also to redundancies of course.
And when we look now at Digital Services we see that all the problems we have are really well confined to BSS and that's why we now make the next step in developing BSS to make sure that we have a profitable business and a competitive offering. So with the reshaping of the BSS strategy, we are very comfortable on the reaching of the guidance, we have given for 2020 for Digital Services.
If we look at the growth for the full year, it was driven by North America and that is as our customers get ready for 5G. What we see the demand for hardware was significantly larger towards the end of the year. Their capacity constraints for tower crew still remains.
I would also point to Europe and Latin America actually returning to growth and that's done despite exits of many non-strategic contracts in that market area. We saw falling sales in Northeast Asia, due to reduced investments in LTE.
In Southeast Asia Oceania and India it was a very tough comparable in 2017 as we have many projects being completed late in the year. The reduction in Middle East and Africa is really due to the geopolitical situation in some specific countries.
If we look at just Q4, it's encouraging to see the growth accelerated throughout 2018. So by the end of the year in Q4, it was only Middle East and Africa that has a reduction in sales and that was really due to the geopolitical uncertainty in certain countries.
So, with that, I'll give the word over to Carl.
Thank you, Börje, and good morning good afternoon, everyone on the call. Thanks for participating.
Let's look at the segments one-by-one starting with Networks. Networks delivered a solid quarter here in the fourth quarter, high -- very high activity level. And the growth FX adjusted of 6% was really fueled by North America, Europe, Latin America and Northeast Asia as well, so quite broad as a sign of the competitiveness of the radio portfolio not least.
And gross margin increased year-over-year. And this is also a function of the product competitiveness and the hardware and services margins improvement that comes out of that as well, the continued penetration of ERS as well as cost reductions were a key to this improvement of margin.
And the operating margin came out at 17.5%, doubled percentage year-over-year. And then we should note that this is in spite of certain impact from strategic contracts that we have taken and the 5G field trials, also supported somewhat with the provision reversal related to accounts receivable of SEK300 million. So the ERS deliveries now were at 93% of the total deliveries in the fourth quarter and so that is continuing on a good path towards 100%.
And then finally looking at the full year 2018, the Networks delivered 15.3% operating margin excluding restructuring. And this is then obviously in the lower end of the 2020 target range.
Move to Digital Services please, and we can look at -- here look at the topline where sales grew 5%. And Börje alluded to this earlier the positive sign here is that we see the new portfolio getting traction and grew by 4% in the full year. This is as you remember one of the key strategic execution KPIs that we set up earlier, the growth in the new growth portfolio in Digital Services and now that has returned to growth. And it's really around our 5G ready virtualized portfolio, cloud core and OSS as I mentioned two areas that delivered well.
The reported gross margin is of course way down by the provision we announced two weeks ago for reshaping the BSS strategy as Börje described just now more in detail. But if we exclude that for I mean net gross margin ended up at 38% or 37.5% to be precise supported by continued cost reductions.
Operating income, again if we exclude the extra business provision came in at SEK0.6 billion negative which is a clear sign of a path towards the 2020 targets of low single-digit. And again this is supported by profit improvement coming in actually all across the key product areas in the segment and very large expense reductions SEK2.6 billion as it says here in the full year. And now that we have addressed 23 of 45 contracts to-date of which four in Q4, we fulfill also that commitment to address half of those contracts within 2018. Another 25% will be handled addressed during 2019.
Managed Services, sales declined somewhat 5% FX adjusted. This is then entirely related to the exit that we have initiated following the renew of these 42 contracts that we identified earlier. All of those are now addressed. We can say that this is a completed action. And this contributed with SEK0.9 billion in bottom line uplift on an annualized basis. And this contributed to the profitability improvement significant such year-over-year together with cost reductions in the deliverable services here and additional efficiency. Full year view tells us that the operating margin landed at 5.3% excluding restructuring. Again as with Networks this is then in the lower range of the 2020 target range.
We move forward to Emerging Business and Other, our fourth segment. And here, we provide some detail on the three main parts here in this segment. The first one being emerging business and iconectiv with strong growth. And Börje explained that earlier as well how we managed this business for positive MPV and always within the 2022 group targets.
Media Solutions this is the area that includes the Media Time business that we are divesting. And as you can see in the numbers here, a lot of cost-out activity has happened during the year leading up to this point. And Q4 was also however impacted by some of the transaction costs related to this divestment.
Red Bee Media, sales down somewhat after renegotiations and scope changes in couple of the contracts there, but losses are clearly reduced. Also that has to do with cost reductions that happened in Red Bee Media. And now we are continuing to develop offerings and also getting traction in the market as well from Red Bee.
Gross margin. Looking at the longer time series here from 2016, 2017 and 2018 and we clearly see that this now is the fourth quarter that we delivered around 36%, 37% gross margin, so we could say that this is a new level established during this year compared with the two previous years.
And again, the important drivers for gross margin here are the cost reductions as we have talked along all along in terms of strategy execution there is a further ramp up of the Ericsson Radio System and the contract reviews that we have undertaken and concluded. Some impact in these numbers so I say this again from costs related to strengthening the market position such as early phases of contracts, trials for 5G et cetera.
But all in all excluding then the BSS provisions, we ended up with 36.3% in underlying gross margin. Costs or OpEx rather there are three buckets we look at here now at in OpEx are: first of all R&D where we follow the strategic intent here to reduce furthering digital services and invest on the other hand in Networks. This has also happened increasing the total R&D amounts somewhat year-over-year.
SG&A, the cost reductions continued here, partially offset then by some of the field trial costs that you can see specified there in the middle graph. And then finally, we also disclosed now the impairment losses related to trade receivables. This can be positive or negative quarter-to-quarter depending on the situation with overdue receivables and whether customers pay us. And this quarter we had a number of positive payments coming in from customers where we earlier had the provisions, so that enabled us to release some of those provisions. But again, this will vary from quarter-to-quarter.
I would like to spend just half a minute or so on taxes because we have quite a large tax costs in the quarter and in this year. So to explain this, I can mention that we have a certain amount of tax assets in our balance sheet. And it's partly related to old losses, loss carry-forwards. And it's also related to withholding tax.
And what is important here is that withholding tax assets can only be used during five years, thereafter they expire. This means that when we apply this against future profits we need to generate such profits within five years to use tax -- withholding tax assets.
And now as we have had losses; now last, but not least and the BSS costs that we did in Q4 that then triggered a revaluation again of tax assets and an impairment of SEK2.1 billion out of the withholding tax assets. And these all resulted in an unusually high tax rate for 2018.
But on average, unless we have this type of extraordinary write-off and similar to the tax rate has been around 32% for Ericsson over the last couple of years. And going forward what will determine this is to a large extent the geographical mix and the tax rates in the various markets and jurisdictions where we make profits going forward.
We turn to Page to cash flow. For the full year 2018 then our operations generated cash flow SEK9.3 billion and free cash flow before M&A was SEK4.3 billion more or less in-line with last year, but a little bit lower. And the reason it was lower was mentioned, but I can repeat a little bit and elaborate from what Börje said.
One is that, we decrease sale of receivable that's the right thing to do, we believe. And the other one is that now we're actually a company in growth mode. And of course, although we work with working capital efficiency a lot and I'll come back to that. We see a working capital increasing as a result of large delivery volumes, large invoicing volumes towards the end of the year which drives up accounts receivable somewhat.
But of course all of that will be collected and converted into cash in the coming periods. We put high focus on capital and costs and cash in our company including a shift of incentives also in this direction. And we put an effort on reducing the lead-times in rollout working on terms of conditions in contracts.
We have strengthened the credit management and the cash collection, just to mention a few of these aspects here. So with that, I can just finally on this slide mention that cash position continues to be strong and strengthen at SEK35.9 billion and gross cash at SEK69 billion as we end the year.
Planning assumptions, finally, we have noted that external firms here the lower one notably expect the equipment market to grow by 2% in 2019 and we concur with that view and the CAGR of 2% then also with 2018 to 2023.
IPR baseline SEK8 billion. Certain strategic contracts in Networks we want to call that out that that might have a certain negative impact on the gross margin. And we also have a cost for 5G field trials as mentioned before and this can weigh somewhat on the margins, mainly in Networks going forward.
However, we are not seeing that that will jeopardize the 2020 financial targets. We will manage this within our overall performance. Then we talk about the R&D expenses expected to flatten out. As you know they have increased in Networks as we have ramped up R&D for technology leadership and this will flatten out now starting in Q1.
And finally, the restructuring charges are estimated to be between SEK3 billion and SEK5 billion in 2019. And I think important here to note that our long-term ambition is to bring restructuring costs down to 1% of topline. And this is what we said -- this is we have stated at the Capital Markets Day. This is one step in that direction, but of course, we need to do more to bring these costs down further.
And other than that I'd like to refer you to the Q4 report, of course, for the complete planning assumptions. This was a selection of those.
With that, thank you. And back to you Börje.
Thank you, Carl. So, if we then look at what are we going to do going forward. Well, we are going to remain focused on executing on our focus strategy for the coming year. Top priorities include on Networks to continue to invest in R&D to strengthen our portfolio for leadership in 5G.
We believe spending will start to flatten out now, but we see quite a lot to do on productivity and R&D. And that's really the fact that we have hired a number of engineers over the last 18 months and it really takes 12 to 18 months to get full productivity on the new hire.
We see as we have mentioned already that we will have costs for some strategic contracts and we will have cost for field trials. As a proportion, they're likely to increase in 2019, but at the same time, we will manage our total P&L like we have done in Q4 as well as earlier during the year when we've had those type of costs.
We're also very comfortable that these type of contracts as well as field trials will actually further allow us to comfortably reach the 2020 targets. So, we are managing the business to make sure that we reach the long-term both 2020 and 2022 targets.
On Managed Services, we have for the first time actually spent some real dollars in R&D in Managed Services. And we do that in order to drive AI use in automation and we're starting to see increasing traction with customers on that.
On Digital Services, of course, we are committed to execute on our reshaped DSS strategy. But most importantly, we really need to make sure that we make our portfolio ready for the future. That includes investments in cloud native as well as ready for micro services. But we also see that we are going to continue to drive the software content in the business as well as meeting the customer demand for the virtualized solutions -- the virtualized network solution.
Our commitment is to reach single-digit margins in 2020 as we have said before. And we are going to execute on that. And the plan we have in place should allow us to show progress during the year on that ambition.
In emerging business, we will continue to invest for the value in five to 10 years in making a stronger Ericsson. So the theme we're going to see here, we will see us drive scale in some of our investments which very promising in IoT as well as edge Compute and we're going to drive those to become contributors to the bottom line over time as well.
So in short, if we summarize, we will continue to focus on executing on our strategy. That includes investments in R&D for technology leadership, but also to maintain cost discipline. With the investments we made in R&D as well as getting competitive cost structure, we are ready for the next step which is disciplined growth. I believe we have already shown that our core business actually has growth potential and we saw that in -- during 2018 and even more so in Q4. We will continue to capitalize on that. We will also make selective investments in emerging business and drive scale there with still the overall commitment to the financial guidance for 2020 and beyond 2022.
We see also that AI and automation is increasingly used in all our business areas and more cross company effort and we are going to increase our investments in that area. Costs and we've have gone through this now multiple number of times, but costs for strategic contracts and field trials will probably be a larger portion in 2019 then 2018, so it could weigh on margin, but we will do this in order to build a stronger company in 2020 and beyond. And we believe these are very good contracts we're taking. We are also increasingly confident in reaching the target of at least 10% operating margin in 2020 and 12% 2022 and beyond both excluding restructuring costs.
With that, thank you very much for listening in.
Thank you, Börje. So operator, we are now ready for the Q&A session. So please, operator.
Thank you. Ladies and gentlemen, at this time we will begin the Q&A session. [Operator Instructions] Detailed information is provided in the reports and Ericsson's Investor Relations and Media Relations teams will be happy to take additional questions and discuss further details with you after the call. Our first question comes from the line of Edward Snyder of Charter Equity Research. Please go ahead. Your line is open.
Thank you, very much. Börje I was interested in especially your 5G contracts or your 5G-ready contract in the U.S. I understand every time we get an upgrade in the systems, do you - presumably more aggressive pricing [ensure] [ph] market share and that is certainly the case last quarter. Does this suggest that you're holding your own, or are you actually gaining share because of this pricing?
And then secondly, in the 4G systems which went through the same kind of cycle, there are a lot of upgrades in 4G both for LTE advanced and LTE Pro. Do you see the same or similar type trend with 5G once it's installed, or we're going to get so much more capacity with initial launch that you don't really have as many upgrades? These are the questions, where is the upside for the aggressive pricing in the follow-on years? Thank you.
I couldn't hear the third part of the question.
Was that about gaining share in the U.S. right?
Yes. The aggressive pricing on 5G contracts, is it holding your share in the U.S. market or are you actually gaining share because of that?
I mean, we will have to see when the total market estimates come out on that. But I would still say that, when we look at the way we price our contracts I think you have to look at the totality here of the company. You've seen us grow market share over the last year on the published numbers by almost 300 basis points and we've done that and at the same time increase gross margin. So it all depends on how you look at pricing, but I think growing share and expanding gross margins speaks a lot about the competitiveness of the portfolio ultimately.
Then speculatively, it's a bit too early to say how the 5G cycle is going to look like. So far, it's really just in the emerging phases of deploying the hardware that's going to create the 5G network. But I am convinced we will see – like has happened in every mobile generation so far you see continuous innovation that's going to drive the need for upgrades over time, I would expect the same pattern in 5G.
Okay. Thanks, Ed. We will continue to the next question please.
Thank you. Our next question comes from Pierre Ferragu of New Street Research. Please go ahead. Your line is open.
Hi. Hi, everybody. Hi, Peter. How are you? Börje thanks for taking my question. So I was interested in this very nice uptick you’ve seen in revenues in Q4. So my understanding is that the large part of that is more like 4G related, upgrading the 4G network increasing capacity, which I assume is very good margins. And a more tiny part of it is the beginning of 5G which is more of a negative driver for margin because I assume it's more like hardware-driven and early-stage contracts. So as we get into 2019, how does that mix evolve? Do you think you're more like at a peak in terms of gross margins and in terms of [revenues] [ph] we'll see more 5G and hardware and all these margin business in the mix in 2019, or do you think we will have like a balanced growth between 4G better margin and 5G temporary lower margins? Thanks.
Yeah. I will start and preface everything by saying we don't guide on 2019. So I'm not going to do that here either. But I think what is happening here and that's why it's worth a little bit longer answers, I think I'll try to address it in a different way. If you look at the history, we've had very low hardware margin. What we have done over the last few years is increase our investments in technology leadership, which actually has allowed us to get a fundamentally different cost position that means we're less exposed to a different mix than we had before. So between hardware, software and services that mix is less sensitive now. The next thing is that is further helped by the costs out we did which actually has made our service delivery much more efficient as well. So when you look now, we are less exposed to different mix of components in our sales.
The second thing, which is important to remember, our hardware has been 5G-enabled since 2015. So to make that 5G -- or carry 5G traffic, it's a software update. So, when we look at we're defining what's 4G and what's 5G, it's increasingly blurred line. And actually, it's not a relevant metric anymore. So customers actually buy our and the reason why we win contract is that they modernize the network and prepare for 5G, but they also need the 4G capacity they get through the modernized network. So it's hard now to say what they are actually doing in that sense. They're doing both, right? And so for us, that's why we look more as in a way 5G-ready shipments as a more relevant metric and then pretty much all our ERS volume is -- since 2015 5G ready.
Thanks, Börje. That's very helpful. And so, do I infer from that that maybe you'll have a bit more stability in margin going forward?
The whole idea with what we're doing with our strategy is to create a more predictable company. That's what we have tried to work on and that's what we continue to work on.
Next question, please.
Thank you. Our next question comes from Simon Leopold of Raymond James. Please go ahead your line is open.
Great. Thank you very much for taking my question. I wanted to first just clarify trending in Digital Services then ask about some longer-term opportunities. Within Digital services, obviously I understand the seasonal patterns contributed to strong December quarter. So, I'd like some help understanding how to think about sort of normalized trends in Digital Services in light of the announcements you've made on the BSS.
And then in terms of trending I know you commented earlier about not seeing evidence of gaining business from the Huawei backlash that's emerging globally. I understand this will take time to play out. But I'd like to hear what you're hearing from customers and see if we can try to quantify a longer-term opportunity if non-Chinese and non-U.S. operators start to shun Huawei? Thank you.
Hi, Simon, Carl here. On the seasonal pattern, yes, there is a certain seasonal pattern I would say in Digital Services. And one of the drivers here is also the fact that we are running project business here. And depending on when milestones happen and not in different projects then all the volumes and profitability will vary. So it's going to be difficult to take one quarter and extrapolate right after that actually.
What I also can say was that in Q4 we had a positive impact also by core contract in Northeast Asia that we have talked about actually a couple of quarters that it would be coming and it did come in, in Q4 so -- and it was sort of delayed from Q2 even and that did come in to impact the numbers in Q4.
And if you take the next one, what we see today is really that I would say nothing that's what we see. We see customers that are raising the question, what does this mean, what's going to happen? They have a concern that's quite clear, but no one really knows. So we have a bit of uncertainty more to put a hold on investments more than anything else. That's what we -- that's the reality of what we see. And then it becomes very speculative to think about what's going to happen, so I rather think that we should run the company from what we know and what we can control.
So what we can control is what solutions do we provide to customers and that’s basically continuing to invest in R&D for 5G leadership and lead the way for our customers into 5G. If we can do that and provide our customers with the best possible solution to deal with the growing traffic as well as create new business opportunities for them, then we have a real business that's sustainable. That's the thing that we will continue to focus on.
Thank you very much.
Thanks, Simon. So, next question, please.
Our next question comes from Sandeep Deshpande of JPMorgan. Please go ahead. Your line is open.
Hi, Börje. I have a question. You talked quite extensively in your opening remarks on the OSS/BSS business of Ericsson and as you rightly said for past many years it has not been profitable. How have you thought about the strategic positioning of that business within Ericsson itself given now that now you've created a very sustainable Networks business? Is it needed in Ericsson along with as ready to be much lower margin than your Networks business? And does it add value to the -- for Ericsson to be in this business in the long term?
If you look to the total, BSS service business that's our core, it's our OSS and it's a BSS basically. What we see is that the link between the Networks business and the Digital Services in the sense of the 5G core as well as the OSS is very tight. So we believe Digital Services it's actually as an important for Ericsson going to be more important in the future rather than less important. And we will see the lines between the 5G core and the RAM to be actually more blurred than anything else.
So and you already know, we need the OSS system from digital services to run the radio network so there it's a very -- we wouldn't sell radio network without that anyway. So we see Digital Services as a critical part of the company going forward. But that's also why we need to get to a certain profitability level and we can't have a partner that's not contributing to the whole. That's why we're focusing on can -- how to turn that around. We knew it would take two to three years to turn it around, but we feel very comfortable on that journey. Longer term, we should clearly find opportunities to have a much better margin profile in Digital Services than the single digit, but I think we need to reach profitability first before we talk about the next step.
Thank you. Next question, please.
Operator: Thank you. Our next question comes from Jorgen Wetterberg of Nordea. Please go ahead, your line is open.
Yes, hi. Thank you. So I wanted to ask a question on the strategic partnerships that you announced with Juniper and ECI in September last year. If you could share some flavor on how that's going and as you're seeing any traction in business-wise from those partnership or if that's more kind of a post 2016 story? Thank you.
Yes, we're -- so, far it's a very small contribution so far to the business. We are still in the early phases of that -- of those partnerships and we are working quite hard to develop some joint offerings and we will see where the partnership takes us over time. That's why you don't see us make a big splash about it. It's more how are we going to develop ourselves right out there and be able to offering end-to-end core routers and edge routers as well. But it feels like we're progressing those discussions quite well. We will see where they take us, so far, very little.
Okay. Thank you.
Thank you, Jorgen. So, next question, please.
Thank you. Our next question comes from the line of Tal Liani of Bank of America. Please go ahead, your line is open.
Hi. Yes, hi, good morning. I have a question on Huawei-ZTE. If the reports are correct and I'm sure that you've had some discussion with your customers about what happens if they want to replace Huawei or ZTE for security reasons.
So, the question is what kind of financial arrangement is going to be to finance it in the sense that could we see -- let's say that it costs $1 billion to replace a current vendor which is what we read is the costs -- some peers are saying that's the cost to replace Huawei. Will you be required to provide vendor financing? If you had any discussions like that with customers, who pays for such a move? Number one.
And number two in that scenario -- in such a scenario where Huawei and ZTE are being replaced for 5G what do you think is going to happen to pricing? Are you going to see them more aggressive in pricing, or what do you expect will happen to pricing and margins, et cetera? I'm trying to understand the implication of Huawei-ZTE as being replaced in certain countries. And if that happens what happens to pricing in the market? Thanks.
I think you asked very good question, but also very speculative question. That is very hard for me to kind of paint that picture. I think this will have to play out in the markets. So, I'm sorry -- I think I cannot really respond to it. I can't really say what is going to happen. What I do think though is that we need to work with our customers to help them solve their problems and that's really the communication problem at the end. That's what we're going to continue to focus on rather than speculate that in the future.
Okay. Let me ask a different question not related. Can you discuss your participation in China? And any of -- do you see -- what are the opportunities there? And do you see all these issues with Huawei and ZTE globally? Does it have any relationship or any impact on your business in China?
China will be one of the first markets in the world to deploy 5G. It's going to be the first to do it on scale. And it will most likely be the first with the standalone 5G network. So we are investing heavily to make sure that we are a technology participant in that evolution of their network. It's an important market for us and we continue to be there. We do the field trials needed. We do all the testing needed and our ambition is to continue to do that.
We will continue to the next question.
Thank you. Our next question comes from the line of Stefan Slowinski of Exane BNP Paribas. Please go ahead. Your line is open.
Yes. Hello. Thanks. Just wanted to follow-up regarding those strategic network contracts, it seems like you've had some nice wins over the last 12 months in the U.S. and Europe and China. And are you suggesting that – I mean, you're suggesting that you're getting impacted by the costs of some of those contracts. But do you think these situations are already reflected in the revenue result in 2018, or does the top line benefit from the strategic contract still ramped in 2019? And secondly, you're implying that you're winning these deals based on technology and the platform. Do you see that advantages as sustainable or was that just a window of opportunity that has closed or will close? Thank you.
What happens is when – the book keeping rules forces you to take the costs upfront and the revenues over time that's what's happening, so that's why it's impacting 2018. On the – if you look at the sustainability of wins in R&D really comes from the continuous investment in R&D. So we established a very competitive portfolio and we are going to continue to offer new features that's going to drive differentiation for the users of our product just like that – that our hardware from 2015 is software upgradable to 5G that has been a competitive advantage for the customers that bought that hardware before.
Even more interesting is for example, dynamic spectrum-sharing which again will benefit from our hardware, where we can dynamically and instantaneously allocate spectrum between 4G and 5G to arrive at a very cost efficient way to build out the 5G network. That's again, a feature very hard for somebody else to do unless their hardware is upgradable to 5G. So, I do believe by continuous investments in R&D like we do now we are going to create a sustainable advantage.
Okay. Got it. Thank you very much.
Thank you very much, Stefan. We are now open for the next question please.
Thank you. The next question comes from Achal Sultania of Credit Suisse. Please go ahead. Your line is open.
Hi, good afternoon. Just one question on the next 5G countries as we think about Japan and Korea next – this year at some point when they begin with 5-year rollouts should we expect the nature of that those contracts similar to what you've seen in the U.S. in the last couple of quarters? More – I'm asking more of this from a margin point of view like should we expect similar kind of a benefit that you've seen in the U.S. to come when the Japanese and the Korean telco start with 5G this year? Thank you.
Still 5G is very early on in its penetration. So, what you see initially is the hardware deployment to solve the traffic needed. And it's typically more 4G heavy and it depends a little bit on individual customers, how that mix looks like. So it's very hard to generalize. But we have no reason to believe that the margin structure we see today would not be the one you would see in the future.
Okay. Thank you.
We are now open for the last question for this session.
And last question in the queue comes from Richard Kramer of Arete Research. Please go ahead your line is open.
Thanks very much. Börje, I'd like to challenge the narrative about Ericsson recovering somewhat because you mentioned restructuring close to 150 times in your release. And it seems to me your comment about being increasingly confident about reaching your margin targets it comes after you've just taken another SEK6 billion in charges. Can you commit now to 2020 and beyond targets which are going to be excluding these exceptionals, provisions and restructuring that we see so often?
And I guess alongside that, you've told me at the 2017 CMD that big cash flow was the real measure of the business in that Ericsson is still delivering returns that are I think it's fair to say well below its cost of capital. Do you -- could you possibly amend your targets to include free cash flow that shows returns above your cost of capital which obviously get affected by these frequent provisions and restructuring charges? Thanks.
Richard, the reality is we come into a situation where the company was in a very bad shape. It's not going to turn around. And I also said that when we met in 2017, it's not going to turn around over a weekend. It's not automatic to turn around in a business where the equipment has a very long life cycle, built upon an investment lifecycle in the beginning and you actually reap the benefits over time. So, the notion that you can make a very quick change and all of a sudden you have turned around I don't believe in that and I said that to you then as well. So what we do is we said that this is going to take until 2020 to get to the first level i.e. 10% operating margin x restructuring.
And we said that longer term we should be at 12%. I'm fully committed to reaching those targets. Over time, we also said restructuring should be less than 1%. I'm fully committed to that target as well. So those are no change. But I also feel that we need to take the actions in order to turn the company around in a timely manner. That's why we took the costs now on reshaping the BSS strategy because it's all about creating a stronger Ericsson, not on Monday next week, but five to 10 years out. That's my commitment. That's my commitment to the shareholders. That's my commitment to the board. That's my commitment to my colleagues. We are here to create a stronger company five to 10 years out.
Okay. Thank you, Richard. And then, we will -- operator continue to conclude this call. And before I hand over to Börje to conclude this I would like just to remind you on the Mobile Congress between the 25th and 28th of February and you're all welcome to sign up for the IR and the media event there, so you're all welcome down there. By that, I would like to hand over to Börje to conclude the call.
Thank you, Peter. So in concluding, we would say we are -- we have -- with the 2018 shown that our strategy, focus strategy by investing in R&D for technology leadership is yielding the results that will bring us to the target for 2020 of 10% plus operating income. We remain committed to continue to invest in R&D for technology leadership as well as to remain disciplined on our cost position and manage the overall P&L and cash flow from our own overall guidance we've given to the market.
So we see now that we have created a strong platform for Ericsson. And from that platform, we can now take advantage of growth opportunity. We are going to do that on a disciplined way and selective way, but we are also now seeing a brighter future and a much more stable company. So we feel overall that we're in a much stronger position today. With that, thank you everyone and have a good weekend.
This now concludes the conference. Thank you all very much for attending. You may now disconnect.