It would seem as though both bulls and bears can agree on one thing were Swedish telecom equipment manufacturer Ericsson (NASDAQ:ERIC) is concerned – the situation isn’t as bad as it looks. The problem is that bears will say “you’re right … it’s even worse”, with ongoing skepticism about the company’s ability to drive meaningful profits and cash flow from its non-Networks business while navigating a significant deceleration in 5G infrastructure investment.
From a valuation perspective Ericsson looks left for dead, as sub-2% revenue growth and modest free cash flow growth can support a fair value over 20% above today’s price. Even so, valuation doesn’t move stocks on its own and Ericsson needs to do more to prove to investors that it can reduce costs/improve margins and wring real value out of its businesses outside of Networks ahead of potential (but still debated) ramps of 5G equipment spending among non-telco customers.
Ericsson’s top-line performance in the fourth quarter was a little bit better than expected. That concludes the good news portion of the discussion, as margins and guidance were both weaker, prompting another round of sell-side cuts to their estimates.
Revenue rose more than 20% year over year (and more than 26% sequentially), beating by about 2%. The inclusion of Vonage gave a big boost to Enterprise (up 265%, and 5% ahead of expectations, and up 15% organically) and the Cloud Software & Services (or CSS) business posted almost 13% growth (beating by 7%, but down 2% organic), helped by a licensing agreement with Apple (AAPL), while core Networks revenue rose almost 15%, missing slightly.
Gross margin fell 200bp yoy and rose about 10bp qoq, missing by more than two points, with misses across the board, ranging from a little less than two points in Networks to over three points for Enterprise. As has been the case for a while, inflation in components and other inputs continues to weigh on results, as Ericsson’s multiyear telco deals typically do not include escalator clauses.
Operating income fell 34% yoy, missing by about 18%, with operating margin down almost eight points (to 9.4%). CSS actually beat by more than two points despite margin shrinking a bit (from 4.2% to 3.4%), while Network missed by a point (with margin down 220bp to 21.4%) and Enterprise missed by almost 10 points on a larger loss (a negative margin of 42.5% versus 41.2% a year ago).
Ericsson missed during all of its quarters in 2022 and guidance for the next quarter and next year were quite weak. Hopefully management is establishing a more beatable bar, but at this point I expect ongoing concern and volatility heading into earnings until the Street regains some confidence about the quarter to quarter numbers.
One of the biggest concerns around Ericsson (as well as Nokia (NOK)) has been the anticipated slowdown in 5G capex spending. While Ericsson management has pointed to a large number of base stations around the world that have yet to be upgraded to 5G (80%, I believe), the reality is that coverage in developed markets like the U.S. and most of Europe is adequate and major customers like AT&T (T) and Verizon (VZ) are pulling back on spending.
With that, Ericsson expects the radio access network (or RAN) market to shrink about 1% in 2023 (the Street was expecting 3% growth, as per Visible Alpha). Management expects North American spending to shrink about 7%, while Europe is expected to be flat, and China is expected to be down about 4% (Ericsson still has a small, but profitable, presence in China).
Moreover, even areas that are growing are a mixed blessing for Ericsson. India should be a source of meaningful top-line contributions as operators there upgrade their networks, but margins there are typically lower.
The RAN market has been one characterized by weak overall growth over long periods of time, punctuated by much stronger years as telcos upgrade to the newest generation. According to Dell’Oro, the RAN market grew just 1% from 2000 to 2020, though growth was much stronger growth in 2020 (17%) and 2021 (12%), and they likewise project just 2% growth from 2020 to 2030.
At some point the 6G cycle will start ramping, but that’s several years out from now. With that, it puts even more importance on Ericsson’s ability to drive growth from non-traditional sources, including enterprise 5G and efforts like CSS.
I’m actually fairly bullish on enterprise 5G, as I do believe industrial IoT is a real opportunity, as well as other use cases like smart cities and smart transportation. The problem is that this likely won’t be ramping for another couple of years, and even then it’s hard to say what impact a move to “Open RAN” could have (an approach that allows operators to use equipment from multiple vendors). Ericsson has been slower to engage on Open RAN than Nokia, and that could ultimately be to the company’s detriment.
As far as other endeavors go, efforts within CSS like network automation and software just haven’t caught on and the business struggles to make any real money despite over five years of restructuring efforts. Now management seems to be more serious about exiting sub-scale businesses to boost profits, while also looking to sign more intellectual property rights (or IPR) deals. Ericsson also paid a steep price for Vonage in 2022 (over $6B), and management will have to prove to the Street that it can really leverage this deal to grow its mobile network and enterprise businesses.
Although I’m bullish on the opportunity in enterprise 5G over time, I’m not sure how quickly it will develop into a real needle-mover for Ericsson. With developed market telco spending on 5G likely to be muted from here, I’m only expecting around 2% long-term annualized revenue growth, and that includes even weaker results over the next three years.
On margins, I’m skeptical that Ericsson can strip out enough costs in the hardware operations and/or ramp the profitability of software and other businesses to drive significant margin leverage in the near term. I do think operating margin can get to around 11% in FY’25, but 14% to 15% EBITDA may be as good as it gets for a while. I’m likewise below management’s targets with FCF margins, with a long-term weighted average margin of around 8%.
As weak as these expectations may seem, they still support a fair value of more than $7/ADR today. Likewise, the forward EBITDA multiple of <5x seems too low for a business still generating low-to-mid-teens EBITDA margins, mid-teens ROICs, and mid-to-high single-digit FCF margins.
Clearly the Street has no faith in the Ericsson story, and given how obsessed the market tends to be with near-term growth, I can understand why there’s not much interest in a stock where the core addressable market is likely to shrink in 2023 and not grow much in the years immediately after. I do think there’s a lot of work left for management to do, including giving investors a reason to really believe in the opportunities within Enterprise and CSS, but at today’s price it seems like a very negative outlook is already in place. I’d prefer to see some quarter-to-quarter stability (vis a vis sell-side expectations) before getting positive, but this is a potential deep-value/turnaround worth watching.
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