One of Ericsson’s biggest problems in the past couple of years has been one its smaller rivals would love to have ‘ too many modernization and coverage roll-out projects. While Alcatel-Lucent and Nokia Siemens have been battling to reverse market share declines, and have been, in different ways, reducing their reliance on actual base station sales, Ericsson has appeared to be sticking to a strategy still heavily geared to the RAN ‘ gaining share and waiting for everyone but Huawei to fall by the wayside. The penalty has been that, in an increasingly commoditized sector, and one where the Chinese vendors have pushed down prices, margins have become increasingly squeezed. Earlier this year the firm blamed this pattern for pressure on its profits, notably for driving its gross margins down to their lowest level, 30%, in fiscal 2011.
Now the strategy may start to bear fruit, as the vendor says it is seeing a gradual but encouraging shift towards higher margin LTE capacity projects, even in recession-struck Europe. Expanding coverage with 3G or even LTE, and modernizing existing networks rather than installing new ones, are tasks with high labor costs and low profits. These have been the core of Ericsson’s business recently, especially in its European heartland, as pressurized operators have tried to eke more out of existing spectrum bands and platforms rather than embarking on new architectures.
However, that is starting to change, and at the point where they need to support massive LTE capacity, they will also have to pursue radical rethinking of their networks (see separate item), with far richer pickings for a broad-based firm like Ericsson. They may adopt new RAN approaches like Cloud-RAN and metrozones, all requiring brand new kit at the back end as well as the cell site; they will need to upgrade transport and core networks with new routers to support all-IP (in the past couple of quarters, routers were a highlight for Ericsson, as they are at ALU); and that will throw up additional revenues for the services and software activities too.
There are some small signs, in Ericsson’s second quarter results, that its patient wait for that tipping point, from coverage to capacity, is near, and CFO Jan Frykhammar said the firm has started to benefit from initial upsell opportunities, notably LTE and core contracts, which could justify taking on the modernization schemes which others might have spurned.
Although it reported flat second quarter revenues because of negative currency exchange, the Swedish giant is starting to see the benefits of its cost cutting program and a slight shift away from low margin modernization projects. However, it suffered from weakness in east Asian markets and the continuing challenge from Huawei everywhere except the US.
Huawei executives spoke last week about the negative impact of effectively being barred from major infrastructure contracts in the US, because of government security restrictions. This is a major boost for Ericsson, which turned north America into its largest market when it acquired many assets of bankrupt Nortel. In the most recent quarter, strong mobile broadband demand in the region, and also in Latin America, was a key highlight.
Ericsson’s sales were unchanged year-on-year at SEK55.3bn ($8.4bn), but would have been up 7% without the effects of foreign exchange rates. Operating profit was up SEK 2.5bn from SEK 2.1bn a year earlier, and margins rose from 2.8% to 4.5%. Net profit increased from SEK1.2bn to SEK1.5bn ($180.7m), even though the year-ago figure was inflated by a one-time gain of SEK7.7bn from the sale of the 50% stake in Sony Ericsson. This time’s result also included SEK900m in losses from offloading Applied Communications Sciences, and exiting the power cable business. The company also took a one-time charge of SEK1.4bn to eliminate 919 jobs in Sweden, about 5% of its domestic workforce. Operating cashflow was a significant positive, reaching SEK4.3bn compared to negative SEK1.4bn last year.
Overall, the networks division revenue rose by 1% year-on-year to SEK28.1bn. Regionally, Ericsson saw north east Asia being weaker than in recent quarters, with a 34% decline in sales in China, Japan and Korea, but it said business was picking up in China thanks to China Mobile’s TD-LTE plans, and also in another key BRIC market, Russia. South East Asia was strong too, up 22%. But in Latin America, sales fell 9%, to SEK4.4bn, as operators postponed building new networks amid delays in spectrum auction, though Ericsson said orders were picking up in the region.
Europe was up 6.3% to SEK11.9bn, with much of that being down to Russia, but also to the pick-up in LTE deals, many following on from earlier modernization engagements. ‘While the macroeconomic situation in Europe remains challenging and the political uncertainty in parts of Region Middle East, such as Egypt, increases, the long term fundamentals in the industry remain attractive,’ CEO Hans Vestberg said in his statement.
By contrast, north American sales rose by 23% year-on-year. In the first half of this year, about 30% of Ericsson’s equipment sales have been made to the big four US cellcos, a record even since the Nortel purchase. This shows how important that deal has been to a company which, before that, struggled to make an impact on the US, partly because of its lack of CDMA products.
However, while the quartet of operators have proved a gold mine for Ericsson, and one that cannot be threatened by Huawei, the LTE roll-outs of Verizon and AT&T will slow from next year as they achieve full coverage and there are concerns about Ericsson being over-reliant on a few customers. ‘The networks division is going in the right direction,’ Hakan Wranne, an analyst with Swedbank, told the New York Times. ‘This is being driven of course very much by the US market, which is basically the four big customers. That is also a risk.’
He also said the markets remained concerned about the price war with Huawei, even though the shift to capacity roll-outs is encouraging. ‘What we have been seeing for several years now, particularly in Europe with the modernization and huge swap-outs of networks, is that those contracts have been taken by Ericsson and Huawei at very low margins,’ he said.
Vestberg said after the results announcement that he expected operators in Europe, North America and parts of Asia to accelerate their equipment purchases in the second half of this year, with an intensifying focus on LTE and on capacity, deals which are not just focused on cell site upgrades, but on more profitable activities like replacing core routers and updating network software to make systems more intelligent.
The CEO commented: ‘You have a new technology push, a roll out of a lot of coverage, you start upgrading and then you begin putting capacity in the networks. In the way we are approaching this mobile broadband technology right now, it will have a major impact on our society. And it is definitely being driven by data and networks.’
Some analysts were cautious about this message, especially how quickly it would boost results. ‘Ericsson’s profitability is a disappointment,’ Hannu Rauhala, an analyst at Pohjola Bank told Bloomberg. ‘They said the business mix would improve, and gross margins were better than last year, but they still have a huge amount of less profitable roll-outs to work through.’
Frykhammar said: ‘On the more challenging side, we have the continued decline of the GSM business in China and also some continued decline of our circuit switch core business. We had somewhat of a challenge, comparatively, in the support solution area; mainly because we sold a lot of compression equipment for the Olympics event in the UK last year. Fundamentally, I think the radio business had a really strong quarter.’
Meanwhile, Huawei has said it is targeting a 9% increase in revenue this year for its wireless networks division, which made sales of $25.7bn in 2012.