Ericsson Takes Giant Leap Toward Profitability
Ericsson has taken a giant step closer to profitability for the first three months of 2018 thanks to hefty cost cutting, a renewed commitment to R&D and the ditching of unsatisfactory contracts. (See Ericsson Reports Q1 Improvement.)
With sales still on the slide, the ailing Swedish equipment vendor reported its sixth straight operating loss as it struggled to execute a turnaround. But that loss narrowed to just 300 million Swedish kronor ($35.6 million) in the first quarter from SEK11.3 billion ($1.34 billion) a year earlier. (See Ericsson: Desperately Seeking Profitability and Ericsson Stuck in Loss-Making Rut, Offloads Majority Stake in Media Unit.)
Table 1: Ericsson Headline Figures for Q1 (SEK Billions)
|Q1 2018||Q1 2017||YoY change|
|Gross margin||34.2%||15.7%||18.5 percentage points|
|Operating margin||-0.7%||-23.6%||22.9 percentage points|
|Cash flow from operating activities||1.6||-1.5||206.7%|
|Free cash flow||0.3||-3.2||109.4%|
|Net cash at end of period||35.6||28.3||25.8%|
|Gross margin excluding restructuring charges||35.9%||18.7%||17.2 percentage points|
|Operating income excluding restructuring charges||0.9||-9.5||109.5%|
|Operating margin excluding restructuring charges||2.0%||-19.9%||22.9 percentage points|
That seemed easily to beat market expectation: Analysts polled by Reuters were reportedly anticipating an operating loss of SEK2.4 billion ($280 million).
The update gave a huge boost to Ericsson during morning trading in Stockholm, with the company's share price up 16.5% at the time of publication.
The improvements came as Ericsson AB (Nasdaq: ERIC) slashed another 3,000 jobs in the recent quarter and said that 18,000 positions (including contract jobs) have been axed since July 2017. The number of full-time employees has now dropped to 97,581 from 111,464 in the final quarter of 2016.
Ericsson's target is to reduce annual costs by around SEK10 billion ($1.2 billion) by the middle of this year. It claims already to have realized savings worth SEK8.5 billion ($1 billion) across a 12-month period, but says not all of these savings have yet fed into quarterly results.
Those remarks will put additional pressure on the company to maintain its recent momentum, and analysts may now be expecting a return to profitability in the second quarter of 2018.
While Ericsson is not providing any concrete short-term guidance on that front, it hints to Light Reading that further improvements may be right around the corner. "After focusing on stability in 2017, profit improvement activities are now accelerated in all areas," says Helena Norrman, Ericsson's chief marketing officer. "Gross margins can vary between quarters but cost reductions will further improve earnings."
Further layoffs look a certainty in the second quarter, as Ericsson aims to hit its cost savings target. The company was last year reportedly seeking to cut as many as 25,000 positions across the company. It has never confirmed that as an official target but is already nearly three quarters of the way there. (See Ericsson Plans 25,000 Job Cuts – Report.)
Norrman says margin improvements are also coming from investments in R&D, which has been ringfenced from the cuts happening elsewhere. Indeed, R&D spending rose from SEK31.6 billion ($3.8 billion) in 2016 to SEK37.9 billion ($4.5 billion) last year, and Ericsson today said it had recruited another 500 engineers for its 5G business. "We need to keep the portfolio competitive," says Norrman. "This is about investing in R&D to get higher gross margins." (See Huawei Dwarfs Ericsson, Nokia on R&D Spend in 2017.)
At both its digital and managed services businesses, Ericsson has also been renegotiating or scrapping what Norrman calls "non-performing contracts."
"As we complete those we are seeing gross margin improvements," she says. "We now competed 31 of 42 managed services contracts that were up for review, and eight of 45 digital services contracts. Digital services will take longer but half of them will be done this year."
Excluding restructuring charges, Ericsson's gross margin came in at 36% in the quarter, up from 19% a year earlier and only slightly below a 2020 goal of 37-39%. At minus 0.7%, its current quarterly operating margin is not even close to the annual target of 10%, which Ericsson similarly hopes to realize in the next couple of years. But as the effect of staff cuts becomes visible in the financials, and as the digital services outfit is hammered into shape, Ericsson should start to close that gap.
Next page: Signs of progress
Signs of progress
Ericsson's problems began in mid-2016, when former CEO Hans Vestberg began to complain about weak conditions in some of Ericsson's biggest markets. Earlier moves into adjacent markets such as cloud hardware and media have not worked out as planned. And in Europe and Asia, Ericsson has struggled to fend off competition from Chinese rivals Huawei Technologies Co. Ltd. and ZTE Corp. (Shenzhen: 000063; Hong Kong: 0763), which have flourished while Ericsson's business has shrunk. (See Huawei Hits $92B in 2017 Sales.)
Under current CEO Börje Ekholm, who took charge in early 2017, Ericsson has been guiding for an improvement in conditions this year. But its revenues have continued to slide in the early part of 2018. Overall sales were down 9% in the quarter, to SEK43.4 billion ($5.1 billion), compared with the year-earlier period, although Ericsson said the decline would have been just 2% were it not for adverse currency movements (and following other adjustments for "comparable units.")
In a nutshell, Ekholm's plan is to make Ericsson a smaller business with fatter margins. Sales next year are expected to be around SEK10 billion ($1.2 billion) less than in 2016 as the company concentrates mainly on being a market leader in 5G, a next-generation mobile technology.
Consequently, and as Ekholm explained during a call with analysts earlier today, sales are falling as Ericsson continues to quit the digital and managed services contracts it deems to be unprofitable. (See MWC 2018: Ericsson CEO Interview.)
Even so, when adjusted for foreign exchange effects, sales were up in North America, the Middle East, Africa and Latin America as some customers began preparing for the rollout of 5G networks and others made improvements to their 4G systems. On the downside, there was a deterioration of conditions in China, where service providers have largely finished building their 4G networks.
On the networks side, overall net sales were down 9.5%, to SEK28.6 billion ($3.4 billion), while the operating margin rose to 13.5%, from 12.8% a year earlier. Profitability growth was driven partly by interest in Ericsson's latest radio platform. Called simply the Ericsson Radio System (ERS), this generates higher margins than earlier systems and today accounts for about 84% of total radio deliveries, up from just 61% of the total this time last year. It can also be "software-upgraded" to support 5G services as and when they are introduced, say Ericsson executives. (See DT Ditches Nokia From Its German Radio Access Network.)
While Ericsson's guidance is based on an assumption it will not see any commercial 5G business until after 2020, Ekholm now expects otherwise. "We think there will be revenues ahead of that, actually," he said. "We will see commercial revenues this year and clearly next year."
Much of that interest is coming from North America, where the biggest mobile operators are busily engaged in a 5G marketing battle and where authorities have blocked Huawei and ZTE from doing business with the major operators.
Indeed, ZTE has now said its very future could be at stake after US authorities this week banned it from buying US-made components for the next seven years. Watchdogs say the Chinese firm issued misleading and false statements after it last year paid a $900 million fine for breaching sanctions on Iran. (See ZTE in Existential Crisis as It Slams 'Unfair' US Ban, Considers 'Judicial Measures'.)
Analysts believe the setback for ZTE could be an opportunity for Western equipment companies like Ericsson and Nokia Corp. (NYSE: NOK), but Ekholm was coy when asked if he had already seen a positive impact.
"I think it is too early to comment on that and our focus is on having a competitive product in the market," he told analysts. "Many customers are asking questions and that is not so strange, but let's refrain from summarizing that yet."
Ericsson continues to guide for a sales decline in the overall market for radio access networks (RAN) of about 2% this year, after witnessing a much sharper fall in 2018, and now expects RAN market sales to increase at a compound annual growth rate of 2% over the 2018-22 period.
The possible risk is that an industry shift to more open and virtualized RAN technologies allows telcos to reduce equipment spending and leads to the emergence of new vendors. (See Nokia Seizes Open RAN Initiative as Ericsson Holds Back.)
Asked if Ericsson's market guidance factored in that risk, Norrman says estimates are based on external views and that Ericsson is currently involved in discussions about the use of open source technology. "We use external sources but we think they are reasonable," she says. "We are looking at future architecture and network possibilities. Those are definitely a part of what we are."
Ericsson's digital services business delivered sales of SEK7.7 billion ($910 million), down from SEK8.4 billion ($1 billion) a year earlier, but narrowed its operating loss from SEK8.8 billion ($1 billion) to SEK2 billion ($240 million) over the same period.
The managed services unit, meanwhile, swung from an operating loss of SEK1.7 billion ($200 million) to a profit of SEK100 million ($12 million) over that period. Sales were down about 8%, to SEK5.5 billion ($650 million).
In "emerging business and other," a grouping which now includes its long-suffering media operations, there was also good progress on margin improvements. While still unprofitable, its operating loss narrowed to SEK1.1 billion ($130 million), from SEK3.1 billion ($370 million) a year earlier, with sales down 11%, to SEK1.6 billion ($190 million).
— Iain Morris, International Editor, Light Reading