A week after Nokia’s acquisition of Alcatel-Lucent was approved by the European Commission, the two companies both reported stronger results. Their timing seemed, for once, perfect, with a marriage now almost certain to take place, and against a backdrop of improving fortunes in network infrastructure (Ericsson also turned in better than expected revenues for the second quarter, while Huawei enjoyed its most impressive sales growth for five years). Unlike the painful mergers that created ALU and Nokia Siemens in 2006/2007, this deal may be one created from a position of strength and recovery, not desperation.
But is that view, which is currently bolstering the two firms’ share prices, really tenable? An improving economic climate, and a new wave of carrier investment in densification, LTE-Advanced, fiber tranport and virtualization, will certainly help deliver enough business to go around, between the three giants, Ericsson, Huawei and Nokia/ALU. However, there is still a strong lurking fear that hindsight will show this August to have been the sunny engagement period – all optimism and high hopes for the future, soon to be dashed on the rocks of reality.
The first risk to the bright future that Nokia CEO Rajeev Suri is describing is well known to both parties – that the actual process of assimilation and consolidation proves so tortured that it distracts the company from the business of competing with Ericsson and Huawei, and leveraging its new scale effectively. Product overlaps, staff reductions or reassignments, communications with nervous customers and a host of other sensitive tasks will have to be undertaken while continuing to generate sales – a challenge which both ALU and Nokia Siemens failed to address from 2007, helping their larger rivals to survive the oncoming economic crash.
As Gartner analyst Sylvain Fabre put it: “The consolidation of their two product lines will be long and painful,” though he added: “At least they will be beginning the effort with both companies in a relatively healthy place.”
Another risk to the optimistic view of Nokia/ALU was highlighted by the European Commission when it green-lighted the acquisition. It justified the approval by saying there will be more competition in the European market in future, and so the deal will not shrink the competitive landscape.
The statement from the EC competition commission said: “Several other strong players are active on the market: Ericsson and Huawei, which together with Nokia are the main players in Europe, along with the Chinese ZTE and the Korean Samsung.” The EC believes the relatively small presence of the last two does not fully reflect the competitive importance of their offerings, and that Samsung, in particular, will increase its presence. “In particular, Samsung is expected to play a more significant role in the near future in relation to the newest generation mobile telecommunications equipment – so-called 4G, currently being deployed, and 5G,” it said in its ruling.
The judgements seem to go against the conventional wisdom that the networking sector will consolidate more and more as vendors chase massive economies of scale. We may not agree with the specific companies the EC has highlighted – though Samsung’s R&D investment in ‘5G’ technologies is huge and may give it a place in the next generation of networks. But the overall conclusion – that it is not inevitable that the infrastructure market will consolidate around just three players – is rational, and deeply concerning for a Nokia/ALU behemoth created on the assumption of consolidation.
In particular, new architectures open the way for new competitors to enter from other sectors – not just 5G, but before that, virtualization, SDN and densification (see separate item). Cisco, Juniper and other enterprise companies will seize on the convergence of networks and IT, and the move to SDN, to boost carrier business; smaller innovators will help to shape 5G along with the giants, as will powerful operators with a strong interest in keeping the ecosystem varied.
So as margins on conventional networking equipment fall, and the move towards virtualization and 5G throws all current pricing and profit assumptions up in the air, Nokia/ALU may face a lethal combination of price wars and increased competition. Having larger scale will help to weather those storms, but this scenario will not deliver the kind of growth that investors are hoping for.
Indeed, Nokia’s Suri himself struck a note of caution. He said Nokia’s Networks unit had enjoyed a “terrific rebound” during the second quarter but warned that conditions could worsen in Q3 because price wars were intensifying. “Conditions are challenging and we need to take out costs wherever we can,” he said on the earnings call. “We are working to mitigate the impact, unlike others yet to acknowledge that market conditions have changed, and we’ll be better prepared down the road.” He also warned that the global market for network infrastructure was “possibly declining this year” except in China, where there is tough competition from local players.
But for now, the two companies can bask in the glow of their impending nuptials. Shares in both leapt when they announced strong second quarter figures this week – Nokia’s by 7.8% and ALU’s by 5.7% (though these gains seem small when set against the performance of the past three months, which has seen the firms’ share value fall by 20% and 27% respectively).
Nokia’s revenues were up 9% year-on-year to €3.2bn, while sales at the Networks unit were up 6% to €2.73bn, driven by a 12% increase in sales at Global Services, which contributed €1.33bn to Networks’ total . Gross margin was 40%, sharply higher than in the first quarter, and up from 38.1% in the year-ago period. Operating profit rose 51% year-on-year to €521m but net profit was €347m, compared to €2.5bn in Q214, when Nokia completed the sale of its handset business to Microsoft.
Network equipment sales increased 3% on last year to €1.39bn, driven by ongoing demand for LTE. The Here mapping unit, which may soon be sold to a group of German carmakers, reported sales of €290m, up from €232m the year-ago quarter and driven by licence sales for embedded car navigation systems, up 12% year-on-year.
The Technologies division reported net sales up 31% to €193m.
Nokia is forecasting full year revenue growth in all units, with an operating margin between 8% and 11% at Networks, and between 9% and 12% at Here.
Meanwhile, ALU made a pre-tax loss of €54m in Q2, reversing the year-ago loss of €298m. Its gross margin rose 2.2 percentage points to 34.8%. The firm posted revenues of €3.45bn, up 5% year-on-year, while its net loss narrowed to €54m from €298m.
Both firms were affected by exchange rate fluctuations, with revenues at Alcatel down 8% at constant exchange rates and Nokia’s down 1%.
Analysts welcomed the figures, and were pleased that both firms were performing well, so there was little prospect of the terms of the acquisition having to be adjusted. Analyst Alexander Peterc of Exane BNP Paribas told Reuters: “Nokia’s quarter was much better than expected on the operating margin and Alcatel’s performance was good as well. There are no signs that the financial results of the companies are diverging in Alcatel-Lucent’s favor, so there is little chance that the terms of the deal are renegotiated.” Some ALU investors had called for better terms, since the French firm’s Q1 results were significantly stronger than those of its Finnish acquirer.
Nokia’s policy of the past few years, of backing away from very low margin or loss-leading deals, is starting to show through in its results. It posted a surprise increase in profits and margins, much of that coming from cost reduction, but also from a rise in average contract value – even though cashflow continues to take a hit from the need to offer low upfront deals to secure long-term contracts, especially in China. Operating profit at the core Networks business unit, which fell sharply in the first quarter, rose by 11% year-on-year. Operating free cashflow was minus €232m in the quarter, reflecting incentive and dividend payments.
Margins were helped by a “mix shift”, as Suri described it, with software accounting for a higher percentage of revenues than it did last year; and with Global Services taking a larger share of the sales total. Services are now 49% of Networks revenue, up from 46% in Q115. That helped Nokia, which has been the most software-driven of the major OEMs, to achieve better operating margins than ALU or even Ericsson, at 5.1% and 5.9% respectively.
However, ALU’s operating profit and margin also outdid analyst forecasts, mainly because of its cost-cutting program. But the French firm’s sales were lower than expectations as it struggled with a slowdown in US spending, which has also hit Ericsson.
Much of the profit improvement at both companies is down to the ongoing and stringent cost reduction schemes both have initiated to adjust to the new competitive realities of the carrier market. Merger and consolidation should add a new layer of cost cutting and prolong the impact of this realignment effort, but it would still be good to see more of the improvements coming from new products and organic growth rather than cuts.
It was announced that CEO Michel Combes is to leave the firm on September 1, and chairman Philippe Camus will hold the reins until the acquisition is completed, at which point Suri will be CEO of the enlarged firm. Combes has achieved one of the key goals he set when he took the reins and initiated a massive turnaround program, the Shift Plan – in Q2, ALU generated more cash than it consumed for the first time since 2006. Combes said in a statement: “The first half numbers clearly show that the group has already delivered on the main aspects of the Shift Plan, launched two years ago.” He added: “Our second quarter 2015 results represent a significant milestone for Alcatel-Lucent, reflecting the first Q2 of free cashflow generation since the merger of Alcatel and Lucent in 2006.”
“Michel can be credited with renewing a company which is now ready to reap the fruits of these efforts, and commence a new chapter in its history,” Camus said.
These two rising stars may have to watch out for new competitors in their core businesses, but the primary impetus behind their merger comes from the need to scale up in order to be able to compete with Ericsson and Huawei. The Chinese giant turned in impressive Q2 results, while Ericsson’s were more of a mixed bag, reflecting the US slowdown. This is changing the balance of power between the big two – when US carriers were the big spenders, Huawei was effectively excluded from the biggest source of network equipment growth, but now that role has passed to China, it can claim the home advantage.
Huawei had three important boasts to make as it announced its results for the first half of fiscal 2015 – it turned in its highest year-on-year sales growth for five years; it is reportedly well on track to hits its target of 100m smartphone shipments this year; and it achieved an operating margin of 20%, more than twice that of its close rivals.
For the first half, Huawei reported revenues up 30% year-on-year to CNY175.9bn ($28.3bn) and said it would achieve “effective growth” in 2015. This is its highest rate of growth since it started reporting interim results in 2011. Its highest annual growth rate in recent years was in 2008, when its full year revenues were up by 33%.
Carrier infrastructure accounts for two-thirds of Huawei’s revenues, making Ericsson, Nokia and Alcatel-Lucent its chief competitors – and like its Swedish arch-rival, it will be waiting to see whether the merger of the other two players will create a more difficult competitive environment, or whether it can benefit from a period of disruption and adjustment.
However, the Chinese company has a different pattern of revenues to those rivals, and a more complex competitive landscape. One, it has a stronger focus on the enterprise, which appeared to be the star of the first two quarters. Huawei does not break out the different operations until its full year report, but its CFO Meng Wanzhou said the enterprise segment had “started to experience accelerated growth”, while she was more cautious about the carrier business, just saying it had enjoyed “steady growth”. She highlighted cloud computing, storage, agile networks and smart cities as strong performers. In its enterprise segment, of course, Huawei competes aggressively with Cisco.
Two, it still has a major devices business, something all its wireless network peers, most recently Nokia, have now abandoned (though the Finnish firm may return to the fray indirectly through its licensing business). This embroils Huawei in the cut-throat price war for the saturating smartphone space, taking on Samsung and Apple, and a group of its compatriots, such as Lenovo, Xiaomi and ZTE.
According to an internal memo seen by Reuters, Huawei is ahead of schedule in reaching its target of 100m shipments this year. In recent years, the company fallen short of its stated goals for handsets – for instance, for 2014 it set a target of 80m units, but shipped 75m. However, its ability to predict its market and control its supply chain has improved, and so its forecasting has become steadily more accurate – while it was 5m units off in 2014, that was far better than a shortfall of 28m in 2012, when Huawei had predicted up to 60m smartphones but actually shipped 32m.
This year, it looks like getting it right, according to Richard Yu, head of the consumer business unit, who wrote in the memo that Huawei had shipped more than 10m units every month since May. According to Gartner estimates, Huawei was fourth largest smartphone vendor in the first quarter with 18.1m shipments and 5.4% share (Samsung, Apple and Lenovo were ahead of it). That figure would not set Huawei up for its 100m target, but Yu’s memo suggests shipments have picked up dramatically in the second quarter, and that Huawei can boost its growth further in the second half. Meng said in her results statement that the midrange Mate7 and high end P8 models had performed particularly well, as well as the Honor family.
The third difference from Huawei’s key rivals is, of course, regional. It is virtually excluded from selling critical infrastructure in the US, and some other major economies, such as India, have also raised the bar for purchasing from Chinese firms, officially on grounds of national security. So while north America is Ericsson’s largest market, and Nokia’s Suri said this week that a stronger US presence would be one of the biggest benefits of buying ALU, Huawei hardly plays there (except in handsets, where it is launching a big offensive this year and is aiming for a top three market ranking in a couple of years’ time).
The lack of US presence is offset by strength in its homeland, where major 4G roll-outs are underway. Meng said of the carrier business unit: “Investment continued to pour into 4G network construction in China. In addition, the growth in global data traffic drives investment in network capacity expansion, while carriers’ digital transformation pushes up investment in the ICT industry. These factors helped us maintain steady growth in the carrier business.”
Since western vendors are able to compete more effectively in China than Huawei can in the US, it needs additional markets and has invested heavily in European customers and R&D, as well as pulling ahead of its competitors in some emerging economies, particularly in Africa and south east Asia.
Huawei also reported an operating margin of 18%, down slightly from 18.3% in the year-ago period but up on the full year 2014 figure of 11.9%. The second half of last year was hit by high marketing and R&D costs, analysts said, but it remains to be seen whether a similar pattern affects 2015. Margins are very healthy for this market – by contrast, Ericsson’s operating margin for Q215 was 5.9%, while Nokia’s for Q115 was 8.3% and ALU’s was 2.5%.
“We are confident that we will maintain effective growth and steady and healthy development in all business segments in 2015,” Meng summed up, though she did not offer specific guidance. It is likely that the smaller units will be the main drivers of that expansion. The enterprise and consumer businesses experienced faster growth than the carrier unit in 2014, increasing sales by 27.3% and 32.6% respectively.
Over at Ericsson, the Swedish firm announced better than expected revenues, up 11% year-on-year to SEK60.7bn (7.09bn). But when adjusted for currency fluctuations and comparable units, sales actually fell by 6%, while the bottom line was hit hard by Ericsson’s ongoing restructuring program, falling 20% year-on-year to SEK2.1bn ($245m). However, this was up significantly on the Q115 figure of SEK1.5bn. Operating margin was up to 5.9%, from 4% in the first quarter, though it was down from 7.7% in the year-ago period. Ericsson said it would have been 10.4% were it not for the restructuring fees.
CEO Hans Vestberg, speaking on the Q2 earnings call, said the mergers between many mobile operators round the world were, in the longer term, “positive because it creates stronger carriers investing in more things – transforming their IT and doing media – so that’s exciting for us”. CFO Jan Frykhammar echoed that, saying in an interview with Mobile World Live: “Once mergers start being executed, there is a service opportunity initially, to support the customers in executing some of their synergies, with IT platforms and networks and so forth. Later on, it provides a capex opportunity as well.”
However, the fact that several rumored US carrier mergers – such as Dish and T-Mobile – have not yet transpired may have held back recovery in the critical north America region, which has been its largest market since it acquired most of Nortel. North American revenues were down 4% year-on-year to SEK14.6bn, but up 19% compared to the first quarter of this year.
“We can only conclude that we have stabilized but are operating at a lower level,” said Vestberg. “The planned mergers haven’t yet happened, the spectrum that has been auctioned is not yet available – those have been the two industrial impacts on investment levels and when those are resolved we’ll see more momentum in the market.”
More broadly, Ericsson expects to see its pattern of revenues for the rest of 2015, and its pace of deployments, to be similar to those of the previous three quarters. That means reliance on China’s intensifying 4G activities; a carrier shift from network modernization to new roll-outs (boosting margins); and more sales coming from the “targeted growth areas” identified by Vestberg at the start of the fiscal year, which include IP switches and routers, cloud services, OSS/BSS, TV and media, and ‘industry and society’ (a lot of that IoT-related).
Ericsson did not comment on the specific performance of these segments though Vestberg has previously indicated that they, collectively, delivered 10% growth in fiscal 2014.
And Frykhammar also insisted that Ericsson had not yet seen any changes in customer behavior as a result of the impending Nokia/ALU deal.
Ericsson has other challenges, aside from a declining number of MNOs to target. Although the US results stabilized, sales are still lower than a year ago as the huge LTE roll-outs by Verizon and AT&T decelerate and the attention shifts towards SDN (software defined networking). Doubts that Sprint will densify its 4G network to the extent previously expected – or will turn to new suppliers such as Airspan for more cost effective approaches – could also hit Ericsson, which is a key supplier along with ALU and Samsung.
The company clearly needs to spread its regional business even more widely to offset north American stagnation. So far, predictably enough, China is providing a fair piece of that upside, though there was good growth elsewhere too – as Ericsson put it, in all regions except the Americas, central Asia and northern Europe.
Like other major players in the consolidating mobile sector, Ericsson is forced to chase profit by cutting costs rather than organic growth and high margin offerings. It is seeking to re-establish the latter, by moving laterally into areas like cloud services and quad play platforms, but in the meantime it needs to see the results of its successive rounds of cost cutting – the most recent, announced last month, aims to achieve savings of SEK9bn in 2017, compared to 2014, and will mainly involve job losses in Sweden itself.
However, this is about job shifts as well as just losses, as Ericsson pursues higher growth and higher margin businesses. Frykhammar would not be drawn on where further job cuts might be seen, but pointed out in the interview: “Firstly, we try to become more effective and efficient as a company; and then at the same time we employ both service engineers, solutions architects, for instance, and salespeople who can help us grow our target areas. So there will also be increases in headcounts related to target areas.”
The program incurred restructuring charges of SEK2.7bn in Q215, but Frykhammar claims the cuts are starting to have the desired effect, telling the analyst call: “The impact of reductions announced in Sweden will start to materialize in the second half but still we’re starting to see early signs of operating expenses being reduced.”
Without the restructuring charges and currency effects, operating expenses were slightly down year-on-year, Ericsson said. Operating income excluding the charges was up 49% year-on-year to SEK6.3bn.
EC clears Nokia/ALU deal:
The European Commission’s competition authority has given Nokia’s acquisition of Alcatel-Lucent the green light, with unanimous approval of the deal.
The EC said it assessed the impact of the takeover on competition in a number of areas, such as RAN hardware and core network routers.
It decided there would still be healthy competition in its 28 states because of the strength of Ericsson and Huawei and the likely growth of Samsung and ZTE (see main text).
The EC also said that Nokia and ALU were not overly close competitors themselves – perhaps because the former has moved towards a mobile broadband-only strategy while ALU’s recent strength has been mainly in wireline IP.
Both companies have market shares of up to 30% globally in specific equipment areas, but these had little overlap, it said. Nokia is stronger in the European Economic Area, whereas despite its French headquarters, Alcatel-Lucent’s extensive US heritage while ALU is stronger in north America.
Another area of investigation was whether the market would be more vulnerable to co-ordination between the remaining players, but decided that would not be made easier by the Nokia/ALU deal, “in particular given the importance of technological innovation and a lack of transparency in the markets concerned”.
The acquisition has also been approved by the regulators in Canada, Russia and Albania, and the antitrust review period in the US has expired, which effectively means it’s been green-lighted there too.
ALU hinted during its earnings call that closing could come earlier than the expected date of April 2016 since these key regulatory approvals have already been secured.