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3 May 2022

Big three network vendors boost R&D to mitigate effects of global disruption

The cycle of quarterly results announcements has come around again, and all the three biggest mobile equipment vendors’ statements reflected their challenges – some shared, some individual.

Of course, Huawei’s are the most dramatic and its rotating chairman Ken Hu acknowledged, in a keynote at the company’s Global Analyst Summit last week, that this year could be even worse than the last two.

“We believe that in 2022 we are actually facing more daunting challenges, given the external environment,” Hu said. “Survival is the utmost goal for the company. Without survival then the visions and dreams that we talk about can only be empty talk and that makes it our priority.”

Geopolitical tensions with the USA’s bloc of allies have not eased with the change of US government in 2020, and their effects are now exacerbated by supply chain disruption, plus the impact of Covid resurgence and aggressive lockdowns in key Chinese economic centers such as Shanghai.

Hu cited a list of global pressures that are shared by its competitors, in addition to Huawei’s specific issues – these include th Ukraine war, inflation, the pandemic, rising commodity prices and foreign exchange fluctuations. “Surviving sustainably is very important for the company,” he said.

Huawei’s response is to diversify its product portfolio to make itself less reliant on the business areas that are at the heart of trade sanctions, such as 5G networks, but this means increasing R&D spending – which is hurting margins. It is also focusing on operational efficiency to reduce other costs, and meet challenges that will just get more intense during the rest of 2022, according to Hu.

Huawei invested RMB142.7bn ($21.8bn) in R&D last year, representing 22.4% of the vendor’s total revenue.

On the product front, Huawei announced a longer vision to enable 10Gbps connections everywhere with so-called ‘5.5G’ and ‘F5.5G’.  These would support a broader range of niche network requirements, including a more immersive experience in homes, as well as the low latency and high reliability needed for industrial control scenarios. These launches show the firm pivoting towards enterprise markets, and alternative customers to the telcos, in markets where operators are being restricted in their ability to buy Chinese gear.

It is also looking to resurrect a device business after its smartphone business imploded because of international tensions, and it sold off its Honor mass market brand. It is now developing consumer and B2B2C hardware and software for smart home and for the healthcare, travel and entertainment verticals, as well as non-handset devices such as smartwatches, tablets and speakers, based on its homegrown operating system, Harmony OS. Harmony has been installed on 220m devices so far, with another 100m shipped so far this year, said Hu. And a smart car will launch later this year.

Hu also called on Huawei executives to ensure “quality” in the way they run their operations and in the products and services they deliver. “It is a requirement for all the business units to pay high attention to the quality of their business operations. If they cannot guarantee that, we may have to close down the business,” he warned.

However, despite all these plans and investments, the first quarter figures show the scale of the challenge that Huawei has to address global and geopolitical factors by investing in diversification. The company reported Q1 revenue of RMB131bn ($19.8bn), a 13.9% year-on-year drop, while net profit margin fell from 11.1% a year ago, to 4.3%. This reflected the increased investment in new businesses as well as the fall in revenues, especially from devices. Profits actually rose by 76% year-on-year, but almost entirely because of asset sales, mainly of the Honor handset unit.

Huawei did not release detailed breakdowns of its revenue by business segment, though it said that the carrier business had falled by 7% year-on-year. Hu said the results were in line with the company’s expectations, and indicated that the main signs of hope were in the ICT infrastructure division, which is less affected by geopolitics than the telecoms businesses. “Our consumer business was heavily impacted, and our ICT infrastructure business experienced steady growth,” he said.

This year is likely to see intensification of Huawei’s bid to reinvent itself around non-telecoms segments, as it increasingly sees its carrier and smartphone businesses, especially 5G-related ones, falling back on China and allied countries. The new-look Huawei will pivot towards the cloud and enterprise segments as well as emerging businesses in automotive and digital energy. Last year, Huawei announced a plan to become more agile in targeting vertical opportunities as they arose, creating about a dozen small cross-functional teams to target sub-verticals such as mining.

Huawei’s challenges may be daunting, but its main telecoms rivals, Ericsson and Nokia, are not free of stress either. Ericsson’s first quarter results announcement was overshadowed by the recent scandals related to historic corruption in Iraq, which has led to some shareholders calling for the resignation of CEO Börje Ekholm, and by the enforced pull-back from the Russian market as a result of the Ukraine war. Initially, the European Union had exempted public telecoms networks equipment from its sanctions against Russia, but that policy was reversed earlier this month, forcing Ericsson and Nokia to suspend Russian business.

Stiff penalties are expected from the USA when it finishes its investigation of alleged corrupt practices in Iraq and Ekholm said, on the results call: “We are currently engaging with the Department of Justice (DOJ) regarding the breach notices it issued relating to the Deferred Prosecution Agreement. The resolution of these matters could result in a range of actions by DOJ, and may likely include additional monetary payments, the magnitude of which cannot at this time be reliably estimated.”

He insisted that Ericsson had worked hard for the past decade to strengthen its ethics and compliance programme, adding: “It was actually our improved compliance program that allowed us to identify the misconduct in Iraq that started at least back in 2011.”

Without the factors of Iraq, Russia and supply chain disruption, Ericsson’s recovery, which has been gradually taking shape since Ekholm took over as CEO in 2017, would probably be looking reasonably on-track, despite the impact of Covid-19 and geopolitics, which have slowed 5G build-out in some areas.

For the first quarter, Ericsson reported year-on-year organic sales growth of 3%, with growth mainly driven by the largest business, Networks, and by the Cradlepoint acquisition, which targets enterprise networks. Like Huawei, Ericsson says it is looking to mitigate the impact of global change by investing in R&D in order to establish competitive leadership in the kind of technologies that will help enable global recovery, notably 5G. Its R&D spend increased by SEK1.1bn in Q1, compared to the year-ago quarter.

The main negatives in the quarter’s organic results related to margins, which were hit by the Russia impairment and by a decision to increase inventory, to cushion Ericsson against potential further component shortages. Gross margin fell to 42.3%, from 42.8% a year ago. Another factor was delay of a major recurring contract that would normally be booked in Q1. EBIT margin was down from 10.7% to 8.7% while net income fell by 8% to SEK2.9bn.

Regionally, the geopolitical impact was clear, with Ericsson’s market map showing a clear east-west divide. The biggest growth, at 15% year-on-year, was seen in the home region of Europe and in Latin America, while there was 9% growth in the largest market, North America, which accounts for 38% of sales. Of course, the pull-out from Russia will reduce the European figure in the current quarter – sales to Russia were worth SEK4.1bn in full-year 2021, said Ericsson. Chinese sales are now only 10% of the total and fell by 20% in the quarter – Ericsson has suffered from a Swedish government decision to ban Huawei from the country’s 5G networks. And other Asia-Pacific sales were down 9%, with Ericsson blaming delays to orders or project milestones in Japan, India and south east Asia-Pacific.

While Networks division sales grew by 4% (at constant currency) and the Emerging Business segment (which includes Cradlepoint) by 15% year-on-year, the other two divisions saw sales decline in the quarter. Digital Services was down by 2% and Managed Services by 5%.

Over at Nokia, a different picture emerged. In its largest business, Mobile Networks,  organic, constant-currency sales were down 4% year-on-year, the reverse of the 4% growth in Ericsson’s Networks unit. But profits were up substantially, despite the impact of supply chain problems on overall revenues. CEO Pekka Lundmark, who took the helm in 2020, has made a return to sustainable profitability his chief KPI. When he took over, Nokia had reported a 3.3% operating margin and a net profit of €85m ($89m), on €5.1bn ($5.4bn) in sales, for its second quarter.

Under Lundmark, Nokia has cut over 4,000 jobs, on top of over 6,000 in the year before he took over and has made other cost savings. Some of the savings have been re-invested in R&D, as Nokia, like its main rivals, seeks to compete on technological differentiation rather than price. Its R&D for the most recent quarter was up 8% year-on-year to nearly €1.1bn ($1.2bn).

And its gross margin was up by 2.7 percentage points, to 40.6%, with the Mobile Networks unit’s gross margin rising by 6.6 percentage points to 39.8%. The operating margin would have been 8.6% without a €104m ($109m) charge related to exit from Russia, so in fact was 6.6%. Russia was also a big factor in a 17% fall in net income to €219m ($230m).

The clear improvement in profits since 2020, despite all the global challenges, is driving confidence in Nokia up – its share price has risen by 22% since Lundmark became CEO.

However, there are still organic challenges as well as the effect of global events. The Mobile Networks unit brings in 42% of sales but on constant currency basis, its sales grew only 1% year-on-year in the quarter, to €5.3bn ($5.6bn). This was the latest in a string of lackluster growth stories that show the mobile networks activities lagging behind those of Ericsson, even though the low growth is offset in the corporate figures by strong performance in the fixed networking business, boosted by a boom in fiber-to-the-premise deployment that was accelerated by the pandemic and change in working practices. It was noticeable that Nokia had dropped references to mobile networks market share or to 5G conversion rates from its report this quarter.

Nokia says it is confident that its mobile business “will return to growth in 2022” after sales fell 5%, on a constant-currency basis, in full-year 2021.