Telefonaktiebolaget LM Ericsson: Cautiously Bullish
Summary
- Telefonaktiebolaget LM Ericsson has been weighed down by a below-investment-grade rating of its long-term debt and a $1.2 billion penalty that it settled with the U.S. Justice Department.
- The company generates robust cash flows quarter over quarter and has successfully repaid a significant chunk of its long-term debt in the last 6 months.
- It has also started eating into Huawei’s business, and I’m cautiously bullish on the stock.
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Remember, 2000 was the year of the dot-com bust. The telecom industry lost about $2 trillion in market capital at that time. - Mo Ibrahim
Telefonaktiebolaget LM Ericsson (NASDAQ:ERIC) reported a $326.28 million drop in revenues for the last quarter, but its EPS kept up with estimates. A decline in sales for Digital Services was responsible for the revenue miss. Plus, COVID-19 skewed the timing of contracts. The company also expects Q2 2020 to be softer.
Despite this, I am cautiously bullish on the stock and recommend it as a buy on dips or in an SIP. Here are the reasons why:
Market Penetration
Image Source: ERIC Presentation
Sixty-one percent of ERIC’s sales are from Europe, Latin America, and North America. The rest are from SE Asia, NE Asia, and ME/Africa nations. Revenues grew in Europe but were set off by a decline in Latin America (refer image above). SE Asia and China revenues dived (decline in 4G) while Japan (North-East Asia region) revenues increased.
What’s great to learn is that sales jumped in North America, Europe and Latin America, which together contribute 61% to the revenues. North America, Middle East and Africa witnessed robust 4G and 5G momentum.
With 5G around the corner, ERIC looks well poised in the post-COVID-19 age.
Robust Cash Flows
Image Source: Seeking Alpha
ERIC has reported healthy cash flows in Q1 2020, but it expects a soft Q2 2020. Its business should pick up thereafter per the company’s estimates. For Q1 2020, ERIC reported operating cash flows of $434.8 million. The company has been reducing debt quarter over quarter (you’ll read the reasons downstairs). In the last five quarters, ERIC has repaid $853 million debt, thereby bringing its long-term debt to $2.36 billion as of March 2020 from $3.78 billion as of Sept 2019.
Image Source: Seeking Alpha
ERIC is a cash-rich company, having $5.67 billion in cash and short-term investments as of March 2020.
Peer Comparison
Image Source: Seeking Alpha
ERIC is a step ahead of its peers such as Nokia (NOK), Marvell Technology (MRVL), and Xilinx (XLNX) when it comes to EBITDA. Equipped with a 17.41% forward EBITDA growth and a 42.85% forward EPS growth, ERIC outclasses its peers which are struggling in the single-digit growth phase.
It is likely that after the COVID-19 disruption subsides, ERIC will perform well – so long as it manages the following risks:
Risk Factors
1. ERIC does business in 180 countries. There’s a lot of political buzz going around that many countries will resort to protectionism after the COVID-19 disruption is over. It’s too early to predict how protectionism will impact the company, but it can cause some trouble in the medium term.
2. If the COVID-19 disruption prolongs, it can hurt ERIC’s service delivery, R&D, and supply operations. Vaccine trials are underway as I write this, but it is tough to estimate when the disruption will end. The day a vaccine is successful will be the day when the dark clouds will clear.
3. In December 2019, ERIC agreed to pay $1.2 billion to resolve a bribery case filed by the U.S. Justice Department. The company has entered into a 3-year deferred prosecution agreement (DPA), and failure to comply with its conditions can lead to severe consequences. How this plays out, no one knows – but it is reasonable to assume that ERIC will stay on the right side of the law.
4. For the whole of 2019, Standard & Poor's and Moody’s assigned a below-investment-grade rating to ERIC’s long-term debt. This is why the company has started repaying debt from its operating cash flows. The company has done a solid job of reducing its debt in the last two quarters but must keep at it. Though the debt reduction will benefit the company in the long term, it will stop the company from investing in capital assets or chasing business opportunities in the near term.
Geopolitical Advantage
Europe and America are likely to act in some way against China for causing the pandemic and/or for intentionally withholding data. The U.S. is already making moves to cut Huawei’s chip supply chain.
ERIC will benefit if nations decide to penalize China.
ERIC has already been chosen to replace Huawei’s core network equipment for British Telecom’s 5G network deployment. This happened because the UK decided to limit the use of Chinese equipment in 5G networks.
Events are gradually playing out in favor of American and European vendors, and more favorable events may gather pace after the disruption ends.
Summing Up
Despite the penalty-related setback and the below-investment-grade rating, ERIC is slowly and steadily moving into pole position. It has successfully reduced a significant chunk of its debt in the last 6 months and seems poised to ride out the COVID-19 disruption.
If Europe and America start favoring local 5G companies over Chinese suppliers, ERIC can hit pay dirt.
Though ERIC’s Q2 is expected to be soft, the company has not revised its targets. I am cautiously bullish on the stock and recommend buying it on dips or in an SIP.
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