Ericsson Shares Slump on Gloomy Q2 Update

Ailing Ericsson has served up further disappointment for investors, swinging to a second-quarter net loss of 1 billion Swedish kroner ($120 million) and warning that market conditions will be worse than it had previously feared.

The update wiped about 9% off the value of Ericsson's shares during morning trading in Stockholm. That reversed much of the gain Ericsson AB (Nasdaq: ERIC) had seen under new CEO Börje Ekholm since the start of the year, although at the time of publication shares were still about 2.6% higher than on January 2.

Sales continued to decline, dropping 8% compared with the year-earlier quarter, to about SEK49.9 billion ($6 billion), and by 13% on a constant currency basis.

CEO Börje Ekholm, who took charge of Ericsson in January, is focused mainly on restoring profitability at the business, which has been hit by a market downturn and fierce competition from rivals including China's Huawei Technologies Co. Ltd. and a somewhat reinvigorated Nokia Corp. (NYSE: NOK). (See Ekholm's Vision of Slimmer Ericsson Lacks Detail & Dazzle.)

Yet despite early efforts to improve efficiency, Ericsson slumped to an operating loss of SEK1.2 billion ($150 million) from a profit of SEK2.8 billion ($340 million) in the year-earlier quarter.

In response, Ericsson said it would intensify its cost-cutting activities this year as it works on boosting its operating margin to about 12% from its current level of 0.6%, once restructuring charges are stripped out.

The new target, said the company in a press release, is to implement cost savings with an annual run rate of at least SEK10 billion ($1.2 billion) by mid-2018.

But the outlook seems bleaker than ever: Executives said they were now expecting the addressable market to decline at a "high single-digit percentage" rate this year, having previously guided for a decline of between 2% and 6%.

Nokia expects its own market to shrink by about 2.2% in 2017, although Ericsson insisted that its latest guidance was in line with external market expectations regarding the radio access network sector.

Ericsson now expects to see a "negative impact" of SEK3.5 billion ($420 million) at the operating income level in the next 12 months, blaming an "increased risk of market and customer project adjustments" for the latest forecast.

In addition, it said that a new plan to reduce the capitalization of development expenses and hardware costs would have a negative impact of SEK2.9 billion ($350 million) on operating income in the second half of this year.

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A slump in software sales and lower mobile broadband investments by customers appear largely responsible for the decline at Ericsson's networks business, where revenues fell 8.5%, to SEK36.8 billion ($4.5 billion). And while the networks division remained profitable, its operating margin shrank to 10% from 13% in the year-earlier quarter.

But the situation was much worse at the strategically important IT and cloud business, where sales fell around 5%, to SEK10.9 billion ($1.3 billion), and the operating loss widened from SEK1.1 billion ($130 million) to SEK2.4 billion ($290 million).

Ericsson indicated that lower capitalization of R&D expenses was responsible for the increase in losses and said its gross margin continued to be hit by large digital transformation projects.

It has been exploring "options" for its similarly unprofitable media business and was recently reported to have hired banks to look into the possibility of a divestment. Ericsson's cloud hardware assets may also go up for sale. (See Ericsson Moves Closer to Media Business Sale – Report.)

— Iain Morris, Circle me on Google+ Follow me on TwitterVisit my LinkedIn profile, News Editor, Light Reading

James_B_Crawshaw 7/18/2017 | 8:08:59 PM
IT & Cloud I for one would welcome a disposal of the cloud hardware business if only to get a better sense of how the B/OSS business is faring.

The YoY decline in IT & Cloud revenue (OSS/BSS, Cloud, NFV/SDN, Telecom core, IP routing) of 5% in Q2 is worse than the 3% decline in Q1. In constant currency terms the decline was 10%, primarily due to legacy OSS/BSS (which clearly declined a lot more than 10% given growth in the new portfolio), also worse than the 7% decline in Q1.

The decline in underlying EBITA margins to -14% from -7% in 2Q16 (both losses) seems to be due to a change in accounting policy on R&D capitalization. Under US GAAP you generally have to expense R&D when it is incurred while under IFRS you can capitalize some of it and then amortize it later. It appears that in 2Q16 IT & Cloud capitalized SEK600m more of R&D than it amortized (inflating its profit margins by 5 percentage points versus what would be reported under US GAAP) while in 2Q17 it amortized SEK200m more than it capitalized. The net result is that the losses in the IT & Cloud division under US GAAP would have been 12% of sales in both 2Q16 and 2Q17.

So no sign of improvement on the top line or on margins for the IT & Cloud division. 
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