Dark clouds hang over Ericsson, some light peeping through for Nokia

Ericsson ‘s new CEO presided over his second set of quarterly results since taking the helm, and acknowledged it will take several quarters to turn this ship. Nokia appeared to be profiting from its rival’s troubles, though its own first quarter figures were hardly shiny – revenues fell year-on-year, but only by 4%, an improvement on the year-ago figure of 13%, which hinted at a recovery around the corner. But the shadow of Huawei looms over both Nordic vendors, raising questions over how far they can ever really turn themselves around and return to past glories.

Ericsson CEO Börje Ekholm is in the midst of the latest effort to restructure the company for the new realities of the telecoms world. He has reversed much of the diversification strategy of his predecessor, Hans Vestberg, and is looking to sell the company’s media businesses, and wind back on some other activities he regards as non-core.

This is very much a work in progress, and it is too early to judge the likely results of Ekholm’s plan. In the meantime, the first quarter revealed more losses, and Ekholm said on the analyst call: “It’s difficult because we need to invest at the same time as we work on our cost structure.” Ericsson is pinning hopes on an uptick in carrier spending in its core mobile market, driven by 5G and densification, but this requires the firm to be at the forefront in R&D. At the same time, some of the businesses which Vestberg believed would be vital to future growth have failed to boost the bottom line – Ekholm particularly pointed to accelerating losses in the cloud division.

Ericsson believes the overall RAN equipment market will decline by between 2% and 6% this year and flatten out in 2018. It believes its new Radio System platform, however, could outperform that curve by focusing on prime opportunities in 4.5G and in 5G migration. The platform has helped to stabilize market share and boost profitability in the Networks business, which still accounts for about three-quarters of sales, despite Vestberg’s diversification program.

It is fortunate that it does still have such a commanding role, given the mounting losses in IT and Cloud. But it is deeply worrying for Ericsson that it cannot do better in the cloud, given the convergence of IT and telecoms technologies and buyers.

That highlights a critical choice Ericsson needs to make. Will it remain focused on network equipment, a market under intense pressure, but which it understands well and where it retains significant profile and technical prowess? Or will it expand laterally to spread into areas of higher potential growth?

That was Vestberg’s vision, but Ericsson’s ability to translate its mobile networks expertise into cloud, media and IoT has so far proved limited. Ericsson has initiated a strategic review of its IT and cloud divisions, as well as the media business.
“The strategy builds on reallocating resources and investments to core portfolio areas, fully leveraging the potential of 5G, IoT and cloud,” Ekholm said on the earnings call.

He could reshape Ericsson to be more like Nokia, which is also on a program of lateral creep, but is more concerned with targeting its existing network and server platforms at new users – particularly in industrial markets and the IoT – rather than buying up whole new technologies as Ericsson did with MediaRoom.

Services have been another growth driver, but here there are disturbing problems too. Ekholm said: “Services are developing fairly well, legacy products are falling off faster than we expected”, while IPR licensing revenues were also lower than expected. He also cited non-renewal of managed services contracts, particularly in Ericsson’s biggest market (and the one where Huawei cannot compete for tier one deals), North America.

Managed services, which in some years has been a mainstay of Ericsson’s market reach and revenue growth, are creating problems of their own. Sprint failed to renew major portions of its huge services contract with Ericsson when this was up for review last year; now Ericsson says it expects sales to be negatively affected by about SEK10bn over the next two years, by stripping out unprofitable contracts in managed services and network roll-out. This was a painful process which Nokia underwent before it acquired Alcatel-Lucent, but the challenge remains for all the OEMs – their businesses increasingly rely on services as hardware commoditizes and operators outsource many functions, but price competition in these markets is fierce and margins low.

Ericsson did not shed much new light on how the company might look by 2018,  just repeating previous intentions in its statements: “We will continue to sell complete solutions in telecom core, OSS and BSS, including hardware, software and services,” the company said. “However, we are seeking alternatives for our IT cloud infrastructure hardware business to gain necessary scale to ensure that we can offer competitive solutions to our customers. Tangible improvements in profitability are expected during 2018.”

Ekholm hinted at further cuts too, saying: “The existing cost and efficiency programme is not yielding sufficient results.  Based on current profitability, we will intensify our efforts to reduce cost with focus on structural changes to generate lasting efficiency gains and increase cost competitiveness.”

For the first quarter overall, Ericsson’s sales fell 11% year-on-year to SEK46.4bn ($5.3bn), which would have been even worse (down 16%) at constant currency. The company swung to an operating loss of SEK12.3bn, after a year-ago profit of SEK3.5bn, while its gross margin was hit by restructuring charges, coming in at 13.9%, compared to 33.3% in Q116. Without one-off items it would have been 30.5%, the shortfall coming mainly from lower IPR licensing revenues, which come with high profit levels. The company took SEK13.4bn ($1.5bn) in write-downs and restructuring charges, driving a massive net loss of SEK10.9bn ($1.2bn), compared to an SEK2.1bn ($240m) profit a year earlier.

Ericsson is in ‘jam tomorrow, never jam today’ mode and looks dangerously over-reliant on its traditional mobile operator base, as it sidelines the efforts to reach new customers such as pay-TV providers and cloud operators. To get out of permanent restructuring mode, with the accompanying red ink, it needs its MNO base to move aggressively on Cloud-RAN, densification, LTE-Advanced Pro and 5G – and, of course, turn to Ericsson for their network transformations, not Huawei or Nokia. But despite the high profile 5G trials (almost certainly funded primarily by the vendors), the majority of mobile operators will not make significant 5G investments until the early 2020s.

In the meantime, they are cautious about capex and are trying to squeeze more and more out of existing networks.  But too often this involves virtualization, software-defined networking or WiFi integration – areas where Ericsson has to share the spoils with a diverse supply chain including powerful entrants from the IT/enterprise markets. Its partnership with Cisco should help, with carriers and the enterprise, but so far the tangible results have been limited.

So Ericsson is falling back on its traditional base and hoping that spending here will revive soon, and that it can target new customers via partnerships.

“Our performance in the first quarter continued to be unsatisfactory,” said Ekholm. He said the Networks segment “delivered a solid result despite lower sales, while losses in segments IT & Cloud and Media increased significantly. The immediate priority is to improve profitability while also taking action to revitalize technology and market leadership.

He provided more detail on writedowns, provisions and adjustments which were forced by negative developments late in the quarter, related to some customer contracts and to asset writedowns in IT & Cloud. Ericsson is making negative provisions and adjustments of SEK8.4bn. It said in its statements: “Customer settlements and revaluation of customer discounts, due to lower projected customer volumes, reduced net sales by SEK1.4bn. Operating expenses were impacted by SEK1.5bn due to reassessment of the value of trade receivables.” Additionally, were taken in provisions for additional project costs, mainly related to certain transformation projects in IT & Cloud, “which due to recent negative developments are not expected to be covered by future project revenues”.

Nokia is certainly not out of the turnaround woods, but its Q1 results revealed a company which is further down the road of recovery than Ericsson. Excluding items related to the Alcatel-Lucent acquisition, its sales were €5.4bn ($5.9bn), down 4% year-on-year, a big improvement on the 13% drop of Q116. The biggest unit, Networks, saw sales fall by 6%, pulled down by the fixed, IP, routing and optical activities which were mainly inherited from ALU. The mobile side had flat revenues year-on-year.

Nokia Technologies, which includes patents and technology licensing, saw growth from its handset licensing arrangement with HMD Global and its acquisition of Withings, in the connected healthcare space, last year.

“Nokia’s first quarter 2017 results demonstrated our improving business momentum, even if some challenges remain,” said CEO Rajeev Suri. “We slowed the rate of top line decline and generated healthy orders in what is typically a seasonally weak quarter for us. We also continued to see expansion of cross-selling across our full portfolio, delivered excellent gross margins and improved group level profitability.”

He said the Mobile Networks unit was “clearly the highlight of the quarter” thanks to “robust market interest in our advanced LTE solutions … and ongoing cost discipline”. He said Nokia now has 145 customers for LTE-Advanced solutions.

He also claimed that cross-selling fixed and mobile solutions – to converged operators and to MNOs which need to upgrade their transport networks to support 4.5G and 5G – will drive recovery in the Fixed Networks unit, although it was “impacted by several large deployments coming to an end” in Q1, ending a strong run in 2016.

But recovery in the IP/optical business will require more than telcos. Suri said that division is “heavily weighted towards communication service providers, and that market is currently quite soft. We are making good progress in expanding our business to new customers, including large internet companies where growth is strong, and expect that a coming IP product refresh will strengthen our competitive position.”

Suri is looking for “medium term improvements” in fixed and in IP/optical networks, but the corrective measures – new products, better portfolio selling and cost reduction – need to bear visible fruit during this year to convince investors that permanent recovery is possible, replacing the recent pattern of ups and downs, and that the acquisition of the whole of ALU, including its fixed business, was justified.

Like his counterpart at Ericsson, Suri was not providing many new details of his own refocusing plan, which revolves around “adjacencies” like IoT networks and creating standalone businesses in key areas of telecoms software. One of these is applications and analytics, which currently generates 7% of overall revenues but which Suri’s team thinks could grow to significantly more once it has more autonomy. Sales were only flat, year-on-year, in this business, but that was a big improvement on a 13% decline in the fourth quarter of 2016.