Credit where it’s due – Ericsson (NASDAQ:ERIC) (OTCPK:ERIXF) posted better-than-expected results for the second quarter and the stock responded, rising about 17% since my last update and outperforming Nokia (NOK) and Ciena (CIEN).
While that makes my general bearishness in that prior piece the wrong call in the short term, I’m not convinced I’m fundamentally wrong about the weak long-term picture for Ericsson. Much of the Q2 beat seems to have been driven by a non-repeatable licensing deal and management guidance doesn’t suggest that there’s a meaningful turnaround underway in core customer demand.
I don’t think Ericsson looks all that expensive, and you can make an argument that the shares are undervalued by some metrics, but I struggle to see how Ericsson will deliver better than low single-digit revenue growth and I see increasing pressures on the business from competitors and customers (particularly with a move toward Open RAN likely to pressure margins).
Better Than Expected Q2 Results, But Sustainability Is A Big Unknown
Ericsson posted better than expected second quarter results, with the company largely beating expectations across the board. Underlying results weren’t so strong, though, and I don’t think the outperformance is going to be sustainable given the source of the upside.
Revenue declined 7% in the quarter, but that was still good for a 2% beat. Networks revenue fell 11% and beat by more than 2%, but revenue was boosted by an unexpected improvement in IPR license revenue (up 22% to 3.2B) driven by a one-time benefit that basically drove all of the upside. The Cloud Software & Services business (or CSS) saw flat revenue (2% better than expected), as did Enterprise (a 1% miss), with Vonage down another 7%.
Gross margin improved significantly, up 560bp to 43.9% and besting expectations by more than two points. That IPR license revenue is the real key, though, as a large portion (if not all) of the margin upside is likely due to the contributions of this high-margin line-item. Still, at least some of the upside (relative to the prior year, not relative to sell-side expectations) did come from a mix shift back toward North American sales, and that’s a positive that should continue.
Adjusted operating income rose 10%, beating by about 10%, but here again the contributions from that high-margin license revenue made a huge difference. Still, Networks segment profit rose 8%, with margin improving 150bp to 13.9%.
While the new 5G patent licensing agreement was certainly a positive (management didn’t specify the size of the benefit), it’s not going to be sustainable into the next quarter. While there was still gross margin progress without that benefit, EBITA margin would have been below expectations without it, so I don’t see a lot to extrapolate into a stronger second half.
Better North American Results … Off A Lower Base
Bulls will point to the 14% growth in North American revenue this quarter as a positive, and indeed it is. It’s the first growth since Q3’22 (likewise for Nokia, which saw 3% growth) and North American sales carry higher margins for the company (I’d estimate something around 35% to 45% of the gross margin improvement was due to this mix shift).
As with the patent licensing agreement, though, I think sustainability and magnitude are important to consider. Yes, North America returned to growth, and 21% growth in North American Networks is great to see, but North American revenue almost 40% lower than the last time the business grew (16.6B SEK vs. 26.5B).
Looking at guidance and commentary from other telco equipment providers, as well as the telcos themselves, I don’t think this is a big turn in the industry. Customers built inventories to abnormal levels due to the component shortage issues post-pandemic, and a lot of the recent weakness has been exacerbated by customers working down those inventories. The end of substantial inventory reductions, and/or rebuilding inventories to necessary levels, is a positive, but management guided to only 1% sequential growth for the third quarter despite the Open RAN ramp with AT&T (T), so I don’t think there’s really a lot happening in terms of new project-driven revenue growth.
Management also warned that increased competition from Chinese rivals was at least partly reasonable for the 3% decline in sales in the LatAm/Europe region. This is an unwelcome development for Ericsson (and Nokia) as share takeaway from Chinese rivals was supposed to be a positive driver. If they are, in fact, seeing more traction with customers, Ericsson (and Nokia) will once again be faced with the difficult choice of choosing between preserving market share or preserving margin.
The Outlook
As far as positives to consider, perhaps Ericsson will see better than expected traction in Open RAN and secure additional high-profile wins like the AT&T win. For this to truly be a positive, though, the margins will have to come in stronger than the Street expects, as the main concern about an industry-wide shift toward Open RAN is that the undoing of proprietary hardware components will undermine margins (as has happened in other businesses where there was a shift to open hardware).
It is also possible that Ericsson could see more growth tied to industrial IoT. Numerous companies in the industrial automation space (Emerson (EMR) et al.) have made it clear that they view IoT as a real opportunity, and it will require additional bandwidth capacity to support. How quickly that materializes and how material it truly will be for Ericsson remains to be seen, and likewise with further midband deployments.
Should these not pan out, though, Ericsson could be looking at a three to five-year wait before 6G spending ramps up toward the end of this decade, and that weak revenue outlook will cap margin leverage and free cash flow growth.
Including that eventual 6G ramp, I still expect long-term revenue growth in the low single-digits (around 2% to 3%), consistent with the company’s trailing history. Given relatively weak organic growth prospects, I still believe deployment of capital toward M&A is a real possibility, though the failure of the Vonage deal definitely will color Street perception of future deals.
On the margin side, I expect EBITDA margins to drift in the low-to-mid teens range for a while, though improving sales in North America should help drive operating margins from around 8% in FY’24 (adjusted) toward 11-12% in FY’26. At the free cash flow line, I expect FCF margins in the “mid-high” single-digits (around 7% to 8%), driving adjusted FCF growth in the mid-single-digits (5% to 6%).
Neither discounted cash flow or EV/EBITDA suggest that Ericsson is overpriced, and indeed there is an argument to be made that Ericsson shares could trade toward the high single-digits on the basis of improving margins and returns (ROIC, et al.) over the next few years, with a fair value of $9 not out of the realm of reason.
The Bottom Line
Even though I can come up with a bull-case where Ericsson could be as much as 30% undervalued, it’s also worth mentioning that disappointments have been more common here than positive surprises and the bear-case fair value would be back around $4-$5/share. I don’t see many solid drivers of revenue growth over the near term, and I think the company is going to find it hard to generate attractive growth over the long term as well. Without more evidence of a sustained pickup in capex spending among Western telcos and/or successful diversification into faster-growing markets, I still can’t work up much enthusiasm for these shares.
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