Morningstar | North American 5G Build-Outs and Cost Savings Spur Ericsson's Stellar Quarter; Raising FVE to SEK 66
Ericsson's third quarter beat consensus expectations, with the no-moat firm posting its first positive earnings quarter in two years. Ericsson is thriving under North American 5G build-out demand, while continued cost-saving efforts elevated gross and operating margins. After incorporating the third-quarter results and adjusting our model for slightly higher revenue growth with increased cost savings, we are increasing our fair value estimate to SEK 66 per share from SEK 62, which corresponds to a $7.30 fair value estimate for Ericsson's U.S. ADRs, up from $6.90. We continue to view shares as overvalued.Ericsson's third-quarter year-over-year revenue growth of 9% was led by its networking segment growing by 13%. North American wireless providers are rapidly bolstering their small-cell antenna deployments and upgrading existing 4G antenna sites as data demand continually increases. Compared with the previous third quarter, gross margins increased to 37% from 27% and operating margins increased to 6% from negative 7%. Ericsson's previous development efforts to make its Ericsson Radio System, or ERS, products margin-accretive are paying off, as the installation base increased to 86% of deployments. Additionally, Ericsson's results benefited from exiting unprofitable or renegotiating unfavorable contacts while removing overlapping operating costs.
We continue to posit that Ericsson will be a main benefactor of 5G build-outs, and we believe the company will exceed its stated non-IFRS operating margin goal of 10% by fiscal 2020. However, similar to 4G, Ericsson may have 5G headwinds as well once build-outs occur in price-sensitive economies that contain lower-cost equipment providers. Although we model that Ericsson will beat its fiscal 2020 revenue and operating margin goals, we believe possible market reaction has overvalued the security and that a wider margin of safety is preferred before investing.
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