EUR 850.00 For Business Accounts Only

Morningstar | Ericsson's Fiscal 2018 Showcases Its Turnaround Story; Raising FVE to SEK 69. See Updated Analyst Note from 25 Jan 2019

For fiscal 2018, no-moat Ericsson posted 2.7% year-over-year revenue growth that exceeded our 1% growth expectation, and this marks the company's first year of organic growth since 2013. Strong revenue in the fourth quarter was mainly driven by higher -than-expected 5G demand from North America. Slightly positive operating margin of 0.6% for the year was in line with our expectations. We are encouraged by Ericsson's turnaround progress as 5G demand heats up, and we now expect stronger revenue generation due to Huawei and ZTE blockades. We are raising our fair value estimate to SEK 69 from SEK 62 (for USD ADR, $7.60 from $7.00). With Ericsson trading around SEK 81, the security remains in 2-star territory, and we believe competitor Nokia is a more attractive option.

Demand for 5G hardware was significantly higher than the company expected in the December quarter, which we believe is due to the major North American cellular providers starting their 5G push alongside geopolitical disruptions for Huawei and ZTE. We expect Ericsson, Nokia, and Samsung to benefit from North American, European, and Oceania countries blocking or potentially limiting Chinese manufacturers from selling telecommunication equipment due to security concerns; in turn, we increased our revenue expansion to a 3% average growth rate over the next five years.

Gross margin percentage for the year increased to 32.3% versus 23.3% in 2017, driven by cost reduction measures and negotiating or exiting unfavorable contracts. As Ericsson completes additional 5G test runs, we expect gross margins to increase beyond 35% by 2021. We believe Ericsson frontloaded its 5G innovative efforts, and we model development charges, as a percentage of sales, to decline toward 17% by 2023 versus 18.5% in fiscal-year 2018. We model SG&A, as percentage of sales, to drop toward 11% in fiscal-year 2023 from 13% in 2018 as cost-cutting efforts continue, resulting in operating margins growing toward 8% in 2023.

Within the networks division, Ericsson Radio System now makes up 93% of deliveries, which has a better cost basis and encourages us about the long-term operating margin profile of the business. The firm expects the radio area network demand to be around 2% in 2019, but we expect higher Ericsson demand due to disruptions with the Chinese vendors. We also took notice of Ericsson stating that build out capacity has been constrained due to the lack of tower crews, but we expect this to be resolved as the large carriers make a large 5G push in 2019. The digital services group has addressed 23 of its 45 contracts, and we believe this segment will continue toward profitability as more contracts are renegotiated or exited. As we wrote about earlier in January, a large restructuring effort in its business support system in the fourth quarter should allow Ericsson to focus on now growing the business unit alongside its strong radio network demand. Additionally, although the company recently announced the business support system restructuring efforts, Ericsson will pay out a dividend of SEK 1 per share.