Ericsson’s Q2 results show the strain of the pre-5G spending hiatus

More than any other vendor, Ericsson is showing the strain of a technology transition. It has pinned many hopes for an uptick in its fortunes on 5G, but that will not be deployed in sufficient volumes to drive a real turnaround until the early 2020s. Meanwhile it has to cope with the decline of LTE investments, with fewer alternative sources of growth to tide it over than its main rivals, Huawei and Nokia have.

Huawei has its enterprise and devices business while Nokia has been building up its offerings for vertical markets and harnessing the IP assets it acquired with Alcatel-Lucent. Ericsson, by contrast, has responded to a string of poor quarters by pulling back from some of the new segments it was targeting under previous CEO Hans Vestberg (now at Verizon), and under new chief Börje Ekholm is heavily concentrated on its traditional mobile operator base, and the hopes of an early migration to 5G.

But it could be a long wait for a company which is experiencing its worst crisis of revenues and identity since the telecoms crash 15 years ago. The short term outlook for the core mobile networks business is challenging, as highlighted by a report from analysts at Dell’Oro, which says investment in the RAN will continue to decline significantly for the next three years, only returning to growth in 2021. The firm predicts a percentage decline in base station sales in the high single digits this year, and then two years of less steep decline – in low single-digit percentages.

This cautious outlook has been echoed by Ericsson itself before, though the Swedish company is hoping that 2019 will be flat compared to 2018, rather than continuing to fall. And beyond the RAN, the pattern of MNO investment is changing completely as operators look to improve their cost base with virtualization, especially in the packet core, and with increased use of cloud services, outsourcing and sharing.

“The lull is impacting all regions and all vendors, impacting all three leading vendors, although so far, Huawei has weathered the downturn better than Ericsson and Nokia,” said Stefan Pongratz, senior director at Dell’Oro. “We see some promising signs in North America, but the China market is expected to contract 2017, and Europe will overall see a near term decline. Cumulative radio access network revenues between 2017 and 2021 are expected to represent the weakest period since we started tracking the market in 2000.”

He assesses that LTE RAN sales peaked at $33bn in 2014, on a wave of Chinese roll-outs, and have fallen by almost $4bn since then. They will fall by nearly $6bn more before the 2021 uptick driven by 5G, making a total drop of $10bn over the 2014-2020 period.

These trends were clearly the backdrop to Ericsson’s latest set of disappointing results, with a SKr1bn ($120m) second quarter net loss, and sales and margins figures that came in below analyst expectations. Arun Bansal, head of Ericsson in Europe and Latin America, is cautious about 5G himself, since he believes most operators will not invest heavily until there is more proof that it will directly improve their revenues.

“Operators are challenged themselves and revenues are not increasing and until they do their capital expenditure will not go up significantly,” he said in a recent interview. “5G is still a few years away and unless operators start to create a new source of revenue through industrial use cases, or use cases other than mobile broadband, it will see a gradual rather than a mass roll-out.” He sees the industrial Internet of Things as the biggest hope to drive new operator revenues and so justify 5G, but points out that the priority for the initial 5G standards and technology releases is boosting the data rates – IoT-related enhancements like very low latency will be optimized in later iterations.

“There is no low latency solution until the end of 2018 or 2019, and hence there is no discussion of 5G deployment [in Europe],” he told LightReading. “North America is driving a use case which is more fixed wireless access and more about high speeds — that can already be addressed by LTE-Advanced Pro and then enhanced with 5G. Data consumption in Europe is lower than in Asia or North America and so Europe doesn’t yet see the need for those capacities on its networks.” He sees a lag of between one and three years in Europe for these reasons.

All this raises question marks over Ericsson’s deep focus on 5G and traditional MNOs as it tries to improve its recent poor performance, translate years of cost cutting into improved profits, and survive the 4G-5G hiatus. Announcing its Q2 results, it acknowledged that market conditions would be worse, in the near future, than it had previously thought. That update saw its shares fall in value by 9%, reversing much of the gain which the stock had made since the change of CEO in January.

Sales were down 8% year-on-year to SKr49.9bn ($6bn), and by 13% on a constant currency basis. And worryingly, given the series of cost-cutting measures under Vestberg and Ekholm, operating performance is getting worse. Ericsson reported an operating loss of SKr1.2bn ($150m) from a profit of SEK2.8bn ($340m) a year ago. The firm said it will carry out further cost reduction this year to try to attain an operating margin of about 12% – a tough call since it is currently 0.3%, excluding restructuring charges. The new target is to achieve cost savings with an annual run rate of at least SKr10bn ($1.2bn) by mid-2018, though it is hard to see where Ericsson can continue to find new savings, given the stringent measures it has been taking in recent years.

But Ericsson warned that it expected to see a “negative impact” of SKr3.5bn ($420m) at operating income level over the next 12 months, because of “increased risk of market and customer project adjustments”. It expects the addressable market to decline by a “high single-digit percentage” rate this year, which seemed more negative than previous guidance of 2% to 6% decline. Nokia – which reports its own figures later this week – has previously said it expects a decline in its addressable market of 2.2% in 2017.

At Ericsson’s largest division, Networks, revenues were down 8.5% year-on-year to SKr36.8bn ($4.5bn), though the unit was still profitable. However, its operating margin fell from 13% a year ago to 10%.

There was worse news at the IT and Cloud unit, which was established as a highly strategic operation by Vestberg but has struggled since. In Q217 its revenues were down by 5% to SKr10.9bn ($1.3bn), and its operating loss widened from SKr1.1bn ($130m) in the year-ago quarter, to SKr2.4bn ($290m). Its media business is up for sale and cloud hardware activities may go the same way. As part its ongoing restructuring, the company also plans to shift its IoT strategy from a systems integration-led model to one centered on “platforms and solutions”.

Ericsson said that lower capitalization of R&D expenses was responsible for the bigger losses and that gross margin was still being hit by large digital transformation projects.

Regionally, Japan and South Korea were among the few bright spots. Maynard Um, an analyst at Wells Fargo, wrote in a client note: “Sales in Europe and Latin America (down 11%) were impacted by lower broadband investments while Middle East and Africa (down 17%) faced difficulty in a macro environment. North Africa was stable though declined due to a loss of a service contract and North East Asia (down 3%) saw a decline in China partially offset by growth in Japan and Korea.”

Even Huawei has warned how tough the network infrastructure market has become. Last year, its sales of carrier networks increased by about 24% compared to 2015, but rotating CEO Eric Xu told LightReading in March that achieving a growth rate of “even 10%” in future would be challenging – and that is still well ahead of the small, or even negative, growth rates which Ericsson and Nokia have been experiencing in recent quarters.

Better news from ZTE:

One of Ericsson’s rivals enjoyed a better quarter than the Swedish giant. ZTE – which was hit last year by US sales suspensions and fines linked to alleged illegal dealings with Iran – has bounced back from that and said its net profit for the first six months of 2017 are set to be almost 30% higher year-on-year thanks to strong growth in network infrastructure and mobile devices.

A $900m fine from the US trade authorities wiped out 2016 profits but in the first quarter of 2017, ZTE reported net income up 27.8% to CNY1.2bn ($180m) on sales up 17.8% to CNY25.7bn ($3.8bn).

The latest guidance indicates that the pace has picked up since then and ZTE expects net profit to be about CNY2.29bn ($340m) for the first half of the year, on sales up 13.1% to CNY54.01bn ($8bn).

In a statement, ZTE said it had seen growth “in operations including wireless network, wireline network and bearer network, in addition to handsets, with improvements in gross profit margins”.