Ericsson expects US fines as digital loss hits $5.6B since 2017

"To put it simply, you rock," was the succinct, uplifting message from Ericsson CEO Börje Ekholm to his roughly 100,000 employees on today's first-quarter earnings call.

It is not how financial markets currently seem to view the Swedish equipment maker, despite all its successes under Ekholm's leadership.

Shares were down about 6% in Stockholm this morning after the Ericsson boss warned investors to expect a US fine over a scandal in Iraq, where Ekholm admits former staff may have paid the Islamic State group, a terrorist organization, for the use of roads.

"What I can say is that it is our assessment that it will likely result in monetary measures, but the magnitude cannot be reliably estimated," the early-rising boss told investors and reporters on an unreliable video link from the US. "We are limited in what we can say about historical events."

A fine of the same magnitude as the last settlement with the Department of Justice (DoJ) in 2019 would equate to about $1 billion. Worse is the possibility of "other measures."

Carl Mellander, Ericsson's chief financial officer, declined to speculate when asked what these could be. The chief risk is that US authorities try to block Ericsson's $6 billion takeover of Vonage, a move Ericsson has positioned as critical to its future growth strategy.

Figure 1: Ericsson CEO Börje Ekholm said US fines over an Iraq bribery scandal are likely.
(Source: Ericsson)

Before today's announcement, shares in Ericsson had fallen nearly 24% since February 15, when Ericsson first owned up to misconduct in Iraq.

The company's Mobile World Congress was overshadowed by the affair as US authorities said Ericsson had breached its deferred prosecution agreement – struck in December 2019 after revelations of earlier misconduct across numerous countries – by failing to make subsequent disclosures.

That same week, the DoJ also told Ericsson that earlier disclosures about conduct in Iraq – made before Ericsson paid the last $1 billion fine – were considered "insufficient."

At the time of writing, Ericsson's share price was down 28% on its mid-February level, and today's dip is a worry given Citibank's recent warning the stock may become "uninvestable."

Additional pain points included a cost of 900 million Swedish kroner (US$95 million) on the decision to suspend business "indefinitely" in Russia, where Ericsson generates about 2% of its sales, as well as an unexplained SEK300 million ($32 million) writedown at Ericsson Ventures, the company's investment fund.

Net income consequently fell 8% for the first quarter, to about SEK2.9 billion ($310 million), compared with the year-earlier period.

Underlying strength

Yet most of the underlying business remains strong. Ericsson was still able to boast an 11% increase in sales, to SEK55.1 billion ($5.8 billion) – although growth was just 3% on a constant-currency basis – along with market share gains in Europe.

Huawei, its main Chinese rival, has fallen out of favor in several countries. Nokia, its main European competitor, has paid the price for earlier 5G product problems.

In the meantime, Ericsson has thrived under Ekholm by selling non-core units and doubling down on mobile infrastructure. It continues to ratchet up spending on research and development (R&D), attributing better profitability to these investments, and there was another 11% year-on-year increase for the first quarter, to SEK10.7 billion ($1.1 billion).

Funds are going mainly into a line-up of cloud-based radio access network products as well as next-generation ASICs, the customized chips that Ericsson designs internally for its 5G equipment.

"You can assume we are going to continue at a higher level," said Ekholm. "The return may take a few years but is significant."

Since 2016, just before he took charge of the company, annual R&D spending has risen by SEK10.5 billion ($1.1 billion), to about SEK42.1 billion ($4.5 billion), while Ericsson's gross margin went up an astonishing 21.3 percentage points, to 43.4% last year.

Figure 2: Ericsson's share price (SEK) (Source: Google Finance)

But other costs have been increasing, too. Concern about geopolitics and an ongoing shortage of components has compelled Ericsson to look at the resilience of its supply chains and amass inventory. As a result, it swung to a free cash flow loss of SEK1.7 billion ($180 million), compared with a gain of SEK1.6 billion ($170 million) a year earlier.

That said, at SEK65.2 billion ($6.9 billion), net cash is still 52% higher than it was in March last year. It is with this substantial pool of money that Ericsson hopes to fund its Vonage acquisition.

The company should also have recorded a SEK900 million ($95 million) sales increase from a network software contract that ended up slipping from the first to the second quarter. That should deliver a welcome boost the next time Ericsson reports earnings, helping investors to overlook some of their concerns.

Digital disaster

Ignoring Iraq, Russia and broader geopolitics, the biggest worry is probably the underperforming digital services division, which seems perennially injured.

Despite recording SEK7.2 billion ($760 million) in revenues (up 5% year-on-year but down 2% organically), it recorded an operating loss of SEK1.4 billion ($150 million) for the first quarter. It has now racked up operating losses of SEK52.8 billion ($5.6 billion) since Ekholm took over.

Ericsson insists the 5G product portfolio there is highly competitive, claiming it has signed 5G "core" contracts with 16 of the world's top 20 operators.

On the revenue side, one problem appears to be that legacy sales have collapsed while newer 5G products are still not in use by customers. But executives did acknowledge cost concerns that efficiency measures and automation might help to address.

"This is an area where there have been losses for a long period of time and we need to look at what we can do to improve sales execution and the delivery of competitive products to market," said Ekholm.

The gross margin at digital services fell by 0.6 percentage points, to 42.9%, because of initial deployment costs associated with 5G rollout, and the target of only a "limited loss" this year will be a challenge, said the company.

Want to know more about 5G? Check out our dedicated 5G content channel here on Light Reading.

In terms of sales growth on a percentage basis, Ericsson's best-performing unit by far was the one it calls "emerging business and other," where revenues soared 26% year-on-year.

That division includes the Cradlepoint business Ericsson acquired in 2020 and is where Ericsson records much of the revenue it generates in the fast-growing "enterprise" sector. For the first quarter, however, it accounted for just SEK2.2 billion ($230 million) in sales, a mere 4% of the total, and its prospects might be hurt if the US stops Ericsson from buying Vonage.

The justification for that deal is largely about Vonage's investment in application programming interfaces, or APIs. Ericsson clearly hopes these will give developers the means to write 5G core apps for an entire community of networks.

An app developed with Hong Kong telco SmarTone, allowing customers to boost connectivity when needed at the tap of a smartphone screen, offers a glimpse of the possibilities (and shows they are not confined to the enterprise sector).

"The interest level is very high and the announcement we did with SmarTone generated 150 million unique visitors on the webpage," said Ekholm today.

"The market for APIs will be very large and we can lead and create that market." Provided the DoJ does not interfere, that is.

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— Iain Morris, International Editor, Light Reading