EUR 850.00 For Business Accounts Only

Morningstar | Revenue Prioritized Over Margins in Ericsson's 2Q, Pressure to Continue; Maintaining SEK 81 FVE

No-moat Ericsson's second-quarter revenue of SEK 54.8 billion was well above consensus, but quarterly margin impacts are expected to persist. We have been skeptical about its ability to stave off the temptation of sacrificing margins for revenue gains, and this quarter showcased the decision to grab a larger network footprint and attempt to gain margins over the lifetime of contracts. Ericsson reaffirmed the expectation to hit 2020 margin targets, which we view as a more challenging goal with a lot of margin improvement needed next year after absorbing the high initial costs of network bids. Shares fell over 11% and now trade around our fair value estimate that we maintain at SEK 81 (USD ADR decreased to $8.70 from $8.80 due to foreign exchange); we encourage a wider margin of safety before investing.

Revenue growth of 10% (7% foreign exchange adjusted) year over year was driven by continued momentum in capacity expansion and 5G network buildouts, especially within Northeast Asia and North America. Networks year-over-year growth of 17% (11% foreign exchange adjusted) was helped by more strategic contracts, meant to grab a foothold in customer networks and then expand margins over time. We expect margins to be negatively impacted in second-half 2019 due to an increase in competitive bids and a higher proportion of services post-buildouts. Large 5G deployments and China ramping 5G in the back half of 2019 and in 2020 should also weigh on near-term margins. Digital services grew by 2% (3% decline foreign exchange adjusted) year over year as legacy products declined while Ericsson saw customers embrace its new 5G and cloud-native solutions. Managed services declined by 3% (6% decline foreign exchange adjusted) versus last year as some unfavorable contracts are purposefully exited. The emerging business segment declined 18% annually, due to selling 51% of MediaKind in February, but iconectiv's U.S. contract for number portability helped offset some of the decline.

In the quarter, gross margins of 36.6% fell 180 basis points sequentially, but increased by 180 basis points year over year. Annual margin improvement came from higher IPR revenue, while challenges were due to Ericsson reaching an IPR settlement in June with Intellectual Ventures (terms are confidential, and Ericsson paid $43 million in a jury verdict) and increased strategic contracts. The headwinds in gross margin improvements are mostly due to expanding its footprint within 4G and 5G networks (Ericsson is now live in 15 5G networks). Ericsson is being more competitive in its pricing efforts and we expect margin improvements after the initial buildout stage. Operating margins sequentially declined by 320 basis points to 6.8% (improved 650 basis points year over year) as development and sales efforts were ramped up to win more 5G trials and 4G capacity expansion projects. We expect these efforts to pressure margins for the remainder of 2019 and into the start of 2020, with initial elevated costs to turn into margin expansion in the mid to back half of 2020.