Some green shoots in Ericsson’s Q3, but losses are worse than expected

It was a sign of the low confidence in Ericsson that its shares leapt by 8% when it announced its fourth quarterly loss in a row and a 6% year-on-year drop in third quarter revenue. But hidden in another depressing set of figures were some signs of new shoots of growth in the core Networks business – which will be critical, given that new CEO Börje Ekholm is pulling back on other areas such as enterprise sectors.

Overall revenue in the quarter was SEK47.8bn ($5.9bn) while the loss, its fourth in a row, was SEK4.8bn ($590m), far worse than the year-ago loss of $24.5m. At constant currency, the revenue decline would have been 3%, a significant improvement on a 13% fall in Q217.

Although revenues from the Networks business fell 4% year-on-year to SEK 35.5bn ($4.35bn), Ericsson said it would have grown if adjusted for comparable units and currency, and in light of a decision to revisit some of its managed services contracts. The vendor said its product mix is steadily improving, and the quarter saw higher software sales and significant uptake of its flagship Ericsson Radio System, which now accounts for 55% of its total RAN volumes this year so far, up from 15% in the last quarter of 2016. That platform ties together many portfolio elements to create an end-to-end modular and scalable RAN with migration options for 5G.

But despite these hopeful signs, Ericsson’s largest sector, the RAN market, is still expected to contract by about 8% this year and margins are under severe pressure from operators’ capex reductions, from rising competition, and from the commoditization of hardware.

Operating margins were down in the quarter – by seven percentage points in Networks, to just 1%, and by 26 percentage points in IT & Cloud, to -41%. This meant the overall operating margin just tipped into the negative, at -0.1% (even excluding restructuring charges), compared to 3.1% last year, despite Ekholm’s stated target of improving operating margin to 12% from the end of 2018. Ericsson blamed “higher amortization than capitalization of development expenses” linked to the company’s technology and portfolio realignment.

And the final operating loss of SEK4.8bn was far worse than analysts had expected (consensus was around SEK3.5bn), though it was partly down to one-time restructuring charges of about SEK2.8bn ($340m), including a writedown of SEK1.6bn ($200m) related to the closure of one of Ericsson’s three global IT centers, a move which is targeted to save SEK300m a year. Ericsson said that “customer project adjustments” had lost it another SEK2.3bn ($280m).

Nokia and Huawei are responding to the tight squeeze on their core market by redoubling their efforts to target non-telco customers and to move up the operator value chain with more emphasis on services and emerging architectures such as the multi-access edge. But when Ekholm took the helm he reversed many of the diversification efforts of his predecessor and refocused activities on operators and their networks.

This apparently super-cautious strategy is actually a high risk one, since it makes Ericsson heavily dependent on operators expanding their networks, and preparing for 5G at an early stage – which flies in the face of recent squeezes on telco capex. It also risks leaving Ericsson in the cold when network spending starts to shift to non- operators, with the expected growth in networks-as-a-platform, private networks in shared spectrum, and network slicing.

It would be logical for Ericsson to try to be the controlling entity in a network-as-a-platform or slice manager scenario, but so far Nokia appears better placed to take advantage of such opportunities, with its multi-RAT enterprise-focused platforms, Impact and Wings, and its new alliance with AWS (see lead article).

However, for now at least, Ericsson is starting to show some small progress built on its relentless cost cutting and its streamlining of its target markets. Adjusted operating margins for the Networks business were stronger than expected at about 11% for the first nine months of the year, up from 9% in the year-ago period, driven by the shift to software; the cost cutting; and the decision to review managed services contracts to back away from unprofitable ones.

Ericsson is looking to cut annualized costs by over SEK10bn by mid-2018, with about 30% of the savings coming from general and administrative expenses and 70% from lower cost of sale. The company also cut its headcount by a total net of about 3,000 jobs this quarter. It has been reported to be looking to cut about 25,000 jobs, or about 23% of its total workforce, by the end of June 2018.

Many other divisions are being reorganized or potentially sold off, including pay-TV and IT & Cloud. The latter continued to underperform in Q3, with revenues down 12% year-on-year to SEK10.3bn. However, it will be important to hang on to at least some elements of this division because the core telco customer base are increasingly transforming their networks into cloud platforms and virtualizing their systems in the cloud. So recovery in IT & Cloud would go a long way to reassuring nervous investors.

Now reported as ‘Other’, the media business, which is up for sale (see separate item), saw its sales decline by 13%, to SEK2bn ($250m), and its operating loss rise by 25%, to SEK1bn ($120m).

“The general market conditions continue to be tough,” Ekholm said in his statement and gave particular attention to China, whose abrupt decline in capex spending in 2016 and 2017 has depressed the entire equipment market.

He said: “Sales in mainland China declined as the market is normalizing following a period of significant 4G deployments, representing more than 60% of global 4G volumes in the industry. We have managed to increase our LTE market shares in mainland China to position Ericsson in 5G. However, this will have a dilutive effect on gross margin in mainland China in Q4 2017, but the ambition is to continue to deliver double-digit adjusted operating margin in networks in Q4 2017.”

The statement continued: “We now expand our focus to improve profitability through increased efficiency in service delivery. In addition, we will scale the software part of the business mix and increase the level of pre-integration services, which will lead to a higher gross margin but lower services sales. Positive effects on gross margin are expected in 2018.”