Morningstar | 5G Roll Outs, IPR Agreements, and Restructuring Efforts Bolstering Ericsson; Raising FVE to SEK 81
No-moat Ericsson's first quarter ended with 7% year-over-year organic sales growth (13% in total), driven by North American operators starting to roll out commercial 5G services. Ericsson announced higher intellectual property rights (IPR) agreements signed in the quarter, which increased the gross margin and operating profiles beyond our expectations. With a stronger growth expectation for radio networks and 5G equipment build outs coupled with Ericsson's improvements on the margin front, we are raising our fair value estimate to SEK 81 from SEK 69 (for USD ADR, $8.80 from $7.60). With shares in 2-star territory, we point to competitor Nokia as an alternative investment in this market.The networks division grew by 17% year over year, with network products increasing by 22%, due to robust growth in the North American market and South Korea starting 5G investments. Gross margins increased to 43.2% versus 38.9% in the prior year, mainly driven by strong hardware demand and more high-margin IPR sales. Ericsson announced its transition to selling ERS is complete and there was less impact from lower-margin strategic contracts in the quarter. Compared with the prior year, digital services grew by 7.6%, managed services shrank by 0.7% as contracts were exited, and the other business segment grew by 6.1%. We expect subsequent quarters to be affected by larger strategic 5G contracts and the impact of the lower-margin services increasing.
Looking forward, Ericsson increased its RAN equipment market growth guidance to 3% from 2% (per Dell'Oro forecasts) and expects lower-than-normal sales seasonality as North American sales remain elevated. Gross margins are expected to be impacted by entering strategic contracts after the first quarter, increased services in North America, and large 5G deployments in Asia toward the end of 2019. We believe Ericsson will reach its stated goal of adjusted operating margins of at least 10% by 2020 as it reels in operating expenses.
In the quarter, Ericsson benefited by SEK 1.6 billion due to the recovery of a previously written off receivable and divesture of some of its media assets. Fifty-one percent of MediaKind was divested on Feb. 1, and Ericsson announced the intention to acquire Kathrein's antenna and filter business in the quarter to help bolster its antenna technology. On the earnings call, Ericsson provided a slight update on the investigation of the SEC and Department of Justice regarding the Foreign Corruption Practice Act. Ericsson has recently begun settlement discussions but could not provide a timeline and did note there will be material, including financial, consequences.
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