Telefonaktiebolaget LM Ericsson (publ)
Q3 2022 Earnings Call Transcript

Published: 20 Oct 2022

[Peter Nyquist:]

Good morning everyone and welcome to today's presentation covering the Third Quarter in 2022. With me here today I have Ericsson's CEO, Börje Ekholm and our CFO, Carl Mellander. As usual we will end the presentation with a Q&A session and in order to ask questions you will need to join the conference by phone. Detail can be found in today's press release as well as on the website, ericsson.com/investors. Please also be advised that today's conference is being recorded. But before handing over to Börje Ekholm, I would like to say the following. During today's presentation, we will be making forward-looking statements. These statements are based on our current expectation and certain planning assumptions which are subject to risks and uncertainties. The actual results may differ materially due to factors mentioned in today's press release and discussed in this conference call. We encourage you to read about these risks and uncertainties in our earnings release this morning as well as in our annual report. With that said, I would like to hand over the word to Börje. Please, Börje?

[Börje Ekholm:]

Thank you, Peter. Good morning everyone and thank you all for joining us. I'm pleased to present another quarter with solid underlying performance, and we continue to see robust performance in our business as well as market momentum. Since 2017, we've been able to increase our RAN market share from about to 33%, up to 39% if we exclude Mainland China. We've taken market share from all competitors, including our European, and we have continued to add to our global footprint during the past quarter. So we're really talking about here of some massive gains in overall footprint for Ericsson. These achievements are really based on our focus on technology leadership, and I would say technology leadership allows us to offer our customers leading technologies and highly competitive solutions. Equally important is that it allows us to do product substitutions to manage our margins. In the quarter we also took a key step in our enterprise ambition by closing the acquisition of Vonage. It's really an exciting step for Ericsson, as Vonage will be a critical building block in our enterprise strategy, and it will underpin a full range of cloud communication solutions. We aim to transform the way advanced 5G capabilities such as speed, latency and network slicing are exposed, consumed, and paid for, and we believe this will ultimately help our customers to monetize their network. We expect the Vonage acquisition to be highly accretive, and it compliments our enterprise wireless solution offerings with Cradlepoint and dedicated networks. Overall, we expect our enterprise offering to have a growth potential north of 20% per year. So let me go through some of the key takeaways from this quarter. In the quarter we saw organic growth of 3% with EBITA of SEK 7.7 billion and margin of 11.3%. We saw gross income increase by SEK 3.4 billion and reached SEK 28.1 billion. This increase comes despite lower IPR revenues and was driven of course by the consolidation of Vonage, but also a strong performance in our network segment. Let me comment a bit on IPR. We believe we are in a very strong patent position with more than 60,000 patents, and when we sign license agreements, there will be a retroactive compensation paid for the unlicensed period, and thus it's not really lost sales, but it has a delay. And here we will continue to seek to optimize the value of our portfolio. So it can always lead to some delays in revenue recognition. Networks saw organic growth of 7% if we exclude IPR and this was primary driven by North America where operators continue to be at the forefront of 5G development. Gross income increased by SEK 2 billion and reached SEK 21.4 billion. This result really shows the attractiveness of our leading portfolio built on technology leadership. And this is something we will continue to invest in to strengthen our position and competitive advantage. As I already referenced, we took an important step in the quarter by closing the acquisition of Vonage, and Vonage is really a key cornerstone in our expansion into enterprise. We expect the acquisition to help our customers accelerate their digital transformation, while also shaping how 5G networks will be exposed, consumed, and paid for. In the 4G world, operators could largely only monetize the network through a subscription model. 5G features such as speed latency, but also network slicing offer new and important revenue opportunities, but we don't see that they can be monetized through subscriptions. They have to be paid for as they're consumed. We believe that these new features will be paid for separately for that reason, and the ability to do that will be through what we call network APIs. And with Vonage we have the ability to drive and develop this market. We're really creating a new market for us and for our customers. And here it's interesting to see that we're already working very intensively with front runner customers, basically to develop the APIs, but also to bring them to the market and our customers recognize that this will be a very important monetization engine for them going forward, so they can start to monetize the network investments that they're making. And creating those new revenue sources for our operator customers actually is of course critical because if they can't monetize their investments in their network, they will ultimately not invest in the network. So for us, we believe this will also increase the demand in our business for mobile infrastructure. So we're excited about welcoming Vonage to the Ericsson family, and we look forward to working together now with them to generate value for both Ericsson, but also for our customers of course. Following the reorganization earlier this year, we today present the first quarter for cloud software and services. And as you know, this is a core part of the business, but we also see it's very attractive, but we have not yet realized the full potential in this business. We have a very strong starting position, and by combining the two market areas that we, or business areas that we've done when we form cloud software and services, we believe we can create a stronger unit with clear synergies. And the new management team is further accelerating the transition to profitability and that includes, of course, a strong focus on driving costs down, but also to leverage and solidify our technology leading position as well as market leadership position. We expect this business to have gradual improvements, and we look forward to discussing more of the strategy and more of the plan to reach profitability at our upcoming Capital Markets Day. We continue to engage with the DOJ and the SEC in relation to the 2019 investigation report and the breach notices, and we're fully committed to cooperating with the government authorities. We're also continuing to work to strengthen our culture as well as ethics and compliance program. This work remains one of our key strategic priorities and an area where we will continue to invest in to make sure that we are also a leader in that area. With that, let me give the word over to Carl Mellander, our CFO.

[Carl Mellander:]

Thank you, Börje. Thank you and good morning to everyone. So yes, this is the first quarter then that we report in the new structure with the four segments, networks, cloud, software and services, enterprise and other and also the first quarter where we consolidate in Vonage. The acquisition closed on the 21st of July. So we basically have two months and 10 days or so in our numbers this quarter. But before I start to dive into the numbers, I wanted just to say that I will refer to some gross numbers here, and they will all be adjusted for currency and comparable units. I call that organic for short. And when I talk about profitability numbers, those will be excluding restructuring. I just say it now so I don't have to repeat that 16 times through the speech here. But let's start then with the numbers. Net sales came out to SEK 68 billion. Organic growth in three out of five of the market areas and the organic growth then was 3% for the growth -- for the group and that's despite and SEK 1.1 billion less IPR licensing revenues compared to Q3 last year. But reported sales then grew 21%, of course helped by large currency tailwind, and also the fact that we added Vonage which contributed now with SEK 2.9 billion in sales this quarter. So IPR came out at SEK 1.6 billion. This is in line with the guidance that we had provided in the Q2 report where we said between 1 and 1.5, and we do provide the same guidance for IPR now for the fourth quarter as well, between SEK 1 billion and SEK 1.5 billion. Gross income grew by some SEK 3.4 billion in spite of the lower IPR revenues that I mentioned and growth of gross income really comes from sales increase in networks, given footprint wins we have and Vonage contributed SEK 1.2 billion to the gross income number. Gross margin 41.4% down from 44%. Key reasons there for that decline being then first of all, again, for the third time, the lower IPR revenues, it's about 1 percentage point on gross margin, but we also see supply chain cost in Networks, as we have talked about before. And furthermore, large share of services business, again, coming from the footprint gains that that we have secured over time and that come out in the P&L now in the Networks segment, especially. Looking at R&D, the engine for value creation in our company, we grew that by a SEK 1.7 billion in Q3. FX stands for about a third of that increase. But what we actually invest in here is the -- in the network side is the Ericsson Silicon or the next generation ASICs which enables industry leading radio performance, of course, but also things like energy savings compared to previous generations. But we also invest in the Cloud RAN portfolio which gives our customers more flexible options for deployment in Networks. And thirdly, we also focus R&D money on the, what we call enterprise wireless solutions. It's, it's really Cradlepoint and dedicated networks to further extend or enhance the portfolio there in the offering. SG&A increased by SEK 3.2 billion. Again, big FX impact about SEK 0.7 billion in this case. And the increase here is mainly related to adding Vonage, consolidating Vonage into our numbers because Vonage impacted SG&A by SEK 1.8 billion, and that in itself includes intangible amortizations, which are then, of course not included in our EBITA metric, we will come to that, but also one-offs. And the combination of those intangible amortizations and one-offs is around SEK 0.6 billion of that SEK 1.8 I mentioned. So coming to EBITA then SEK 7.7 billion decline of 1.6 year-over-year, and this is an 11.3% EBITA margin. And again, I want to point out, we did have some one off costs here including the M&A transaction costs that we talk about for the Vonage transaction. So in essence, the, the increase we saw in gross income which is the fruit of winning market share footprint, increasing sales, was more than offset by the increase in OpEx, which I just described, and mainly for technology investments, adding Vonage into our Ericsson family and currency. So that leaves us with a net income of SEK 5.4 billion. And here I can say this is supported by a lower income tax also. So the tax rate now for Q3 was at 25% compared with 30% a year ago. Finally here, the free cash flow came out at SEK 2.5 billion, and we continue to build buffers in inventory in order to meet deadlines of customer deliveries, and I'll come back to that a little bit more when we talk working capital and cash flow. So on a rolling four-quarter basis, our EBITA margin was 12.8% and that we can compare with our long-term target of 15% to 18% EBITA margin. So from that, we can move to the next slide and drilling a little bit more into the segment numbers. So starting with the mobile infrastructure piece, which consists of Networks and Cloud Software and Services. Networks, then, Börje already mentioned it's organic growth of 4%, but excluding IPR, which is a special case, as we all know, given renewal negotiations, the growth was actually 7%. Gross income, SEK 2 billion added year-over-year following the added sales that we talk about. And gross margin, 44.4%, that's impacted, again, by the lower IPR revenues, of course of which Networks record 82% as you know, but also some increased cost of components and supply chain investments there. In Cloud Software and Services we decreased the sales organically by 5% primarily, again, due to the lower IPR contribution. And here we have 18% of IPR recorded in this segment. But we also saw some descoping of some of the many services business we have, some of those contracts decreased, and that's what we see in the minus 5%. Gross income in this segment, stable with a margin of 32.1% and EBITA negative SEK 0.7 billion in the quarter. Finally, then on the Enterprise side, now the share of total sales in enterprise has grown out to 8% in the quarter. The Enterprise sales has a total of Ericsson sales. And we did see very strong growth here with 21% organic by successes in Cradlepoint. The reported sales, of course, up SEK 3.6 billion or so and that has to do with adding Vonage of course contributing with SEK 2.9 billion as I mentioned. So EBITA here in Enterprise, I want to comment also was minus SEK 1.2 billion compared to minus SEK 0.5 billion previous year. And the decline here is mainly due to one off acquisition costs and some of this accounting for the acquisition accounting that we talk about with sales step down, et cetera. But excluding these items, I want to say also that Vonage was EBITA positive in the quarter. Next slide. Looking at the market areas a bit more, we do see strong traction as mentioned for the solutions, and that is resulting in increased footprint. And we saw strong organic growth here in North America with 9%, but also Southeast Asia, Oceania, and India, which is one of the five market areas as well, with 13% up. In Northeast Asia, we saw a decline of 6% and in Middle East and Africa sales grew by 3% organically. And finally then Europe and Latin America sales were flat year-over-year. And finally on this slide, I just wanted to highlight that when we talk about the market areas, this is about our mobile network infrastructure business of course, but in addition, we have the Enterprise piece, which we now book in market area other, just to make that clear. Okay, if we go to the next one and talk a little bit more about the cash flow side then, a key metric for us, of course is free cash flow before M&A and a SEK 2.5 billion impacted by the inventory buildup that we talked about component inventory. In comparison, Q3 2021 had higher than normal cash collection from customers, including rather large amount of prepayments, but also lower than usual payments to suppliers. But this quarter we instead saw, yes, good collection but also impacted then by inventory, which is back to the proactive decision to safeguard delivery times to customers. Based on what we see now, current visibility, we expect this component inventory to come down towards the end of the year and into next year. At the same time, I want to mention, in terms of being forward looking here, that given market share gains or footprint gains that we have, we believe that working capital will remain on a rather high level as we roll out large volumes globally. So gross cash position after this quarter now is SEK 45.8 billion and net cash is SEK 13.4 billion. And I would say we have a well-balanced maturity profile here for resilience with maturity profile of 4.1 years, which is a slight increase from a year ago. Maybe just final comment on this slide when we look at, again, the rolling four quarter perspective we have generated SEK 18.8 billion of free cash flow before M&A and that's 7.3% of net sales. And you can compare that again to the long-term target of 9% to 12% of sales. Next slide is, I wanted to spend a few minutes on the Vonage acquisition and how the purchase price actually translated into our accounts here. Basically starting with the US$ 6.3 billion that we announced when we closed the acquisition and I would like to guide you from that to the numbers that you can see then in our cash flow statement. So first of all, we have a net debt, SEK 7.1 billion deducted. Then there are some deferred considerations here SEK 2 billion that's mainly related to employee benefits and stock-based compensation. And finally, we had a benefit here from hedging SEK 3.7 billion, well done by the treasury team in terms of setting this hedge up for this particular acquisition. And that all results in the SEK 51.3 billion paid as you can see here in the bottom of the table and in the report. I can also mention that during the quarter, during Q3, we repaid SEK 5.9 billion of Vonage's existing debt and both the debt side and these shares were paid by cash on hand. Before leaving this, I wanted to mention one item here and I refer you to the other information in the report, because there we talk about discussion between Vonage and the Federal Trade Commission, FTC in the U.S. around historic consumer practices. And there is an estimated here already provided for in Vonage's book of $100 million. And depending on timing of this resolution, et cetera, and the specifics we might see the cash outflow from that happening in the fourth quarter. Yes, you also see we stated the goodwill and intangible asset numbers here. It's in line with what we have said before. So goodwill, according to the preliminary PPA SEK 43.7 billion and intangible assets 21.9, and therefore we expect amortization to be about SEK 2 billion per year. Move to my last slide for today. This is about outlook for Q4 and also for next year to some extent. And this is repeating on what we are saying in terms of providing information forward. Starting with some specifics for the fourth quarter, then IPR again, we estimate that to be between SEK 1 billion and SEK 1.5 billion IPR revenues in Q4. OpEx has seasonality. It typically increases with some SEK 3.1 billion between Q3 and Q4 and for Q4, I think this could be a pretty good indication where we're heading, but of course a bit of caution there can always be some large variations between quarters. Then regarding Networks, after this record CapEx that we've seen and are seeing in North America in 2022 where we expect the RAN market to grow by 12%, we see that the investments are expected to hold up well during 2023, albeit at a slightly lower level or lower level than 2022. And we expect that initial adjustment of CapEx levels to materialize is somewhat already in the fourth quarter. At the same time, and this is important, we see revenues from footprint wins in other geographies accelerating during the fourth quarter, and we are, we expect that this will compensate for potentially lower sales in North America in the fourth quarter. And as mentioned and some of these footprint gains as we have stated before also. In early stage and large scale projects, we might have a dilutive impact on the gross margin. But of course, as Börje mentioned earlier in his introductory remarks, we focus a lot on increasing the absolute SEK [ph] amount here in gross income. So and looking at 2023 then the global footprint gains lead to an expectation. We have that 2023 will imply additional growth. So, one more thing on Networks then. We state in the report that we now expect Networks to exceed for 2022. The financial target range that we had provided for Networks, which was 16% to 18%, we expect them to exceed that somewhat. And in Cloud Software and Services, we are now saying in the report that we expect full year 2022 result to equal 2021 full year results. Finally, just a couple of words before I hand back over to Börje, a couple of words on the inflationary environment that the world is experiencing now and of course, we are taking action to respond to that situation. Basically three fronts. First of all, we are making pricing adjustments with customers, but we also leverage product substitution as a very important mean to rebase our pricing. And here of course, technology leadership is key again, through our R&D investments with the idea to bring new value adding products to the market. We are also as Börje mentioned, but I'll repeat simplifying operations in our company and reviewing our options to reduce cost. And we talk in the report about redundancy or a structuring cost rather, which we have since earlier a guidance of 1% of net sales. And we will, of course come back to that. And all of these actions are of course to ensure that we secure our ability to deliver on the long-term financial targets for the Group, which is, as you know, 15% to 18% EBITA excluding restructuring. So with that, I hand back to our CEO, Mr. Börje Ekholm.

[Börje Ekholm:]

Thank you, Carl. So to sum up, we've delivered another solid quarter with good business momentum. As you know, our strategy is based on leadership in mobile infrastructure and the focused expansion into Enterprise. Mobile infrastructure clearly remains our core and we're fully dedicated to continue to invest in technology leadership to further strengthen our position. In line with our strategy, we're adding to our footprint, which strengthens our scale and competitiveness. The second leg of our strategy is a focused expansion into Enterprise. Here we added a significant building block by closing the acquisition of Vonage, and we're now starting to have a meaningful presence also in the Enterprise space. In Enterprise Wireless Solutions, we almost doubled our sales compared to last year. I would say our strategy puts Ericsson in a position to continue to lead the industry as 5G is rolled out and transform every sector of our society. As you know, network development in North America has been very strong, and after expected record CapEx in 2022, operators are guiding for lower CapEx in 2023. We expect levels to hold up well in 2023, but they will be at a lower level than in 2022. Globally we continue to further strength on our position by increasing our footprint and we expect to see lower sales in North America for Q4 to be compensated by growth in other regions. However, these contract wins will ramp up to full volume in 2023. We expect our added footprint to give full effect next year, and we expect to see overall growth in networks globally in 2023. To add footprint that's been a critical part of our strategy since 2017 and it will continue to be a priority. We know from experience that early stage large scale rollout projects tend to be dilutive to gross margins. However, the increased volume will increase total gross income and thereby allowing us to continue to invest in technology leadership, which has been the core of our success over the last few years. And if you look at the global 5G market, it's important to, to remember here that the 5G cycle is really just started. The fact is that less than a quarter of global LTE nodes have been upgraded to 5G mid-band so far. And as you all know, mid-band frequencies are critical to fully realize the potential or the performance of a true 5G network. So I would say this shows that there is still a lot of growth potential in the market. I'll just pick one example, India, where we will see a rapid build out of mid-band Massive MIMO. India will likely have the strongest digital infrastructure outside of China, which will drive digitalization of India. Combined this with the new use cases for 5G, both for enterprises, but also for consumers and that includes, for example, fixed wireless access, we see that the demand for network performance and network infrastructure will continue to be at a high level. So we see the 5G cycle both to be longer and higher than previous cycles and previous mobile generations. I'm convinced that with 5G, everything that can go wireless will go wireless. So as we continue to navigate a very complex macro environment and that includes, as Carl mentioned, clear inflationary pressures, but also geopolitical uncertainty. We remain very excited about our future and we're dedicated to the execution of our strategy based on technology leadership. Regarding inflationary pressures, we are already taking actions, and this of course includes a focus on cost and really making sure that our cost efficiency is the key way to allow us to continue to invest in R&D, because again, technology leadership is really what makes the difference and will allow Ericsson to continue to grow. So we are convinced that that also is the right focus to remain successful in this competitive market. And we are super excited about our position in this exciting market. One more thing and that is we are very committed to continue to strengthen our culture, and that of course includes the ethics and compliance program. This is one of our key strategic pillars and an area we will continue to invest in. Based on our strong position, we remain committed to reaching our long-term target of an EBITA margin of 15% to 18% no later than 2024. And, in December, we'll host our first Capital Market Day since the pandemic and we really look forward to welcoming you all in New York. And then we can discuss more in detail our strategy, market developments and our plans to build the competitiveness and future value creation in many years to come. Finally, I would like to say big thank you to Team Erickson. It's a lot of hard work and dedication that's going to make our current position really and the strength of our current position. So I'm proud to be part of this team and thanks everyone for that. With that, over to you Peter for questions.

[A - Peter Nyquist:]

Thank you, Börje. And so we have now 30 minutes for a question-and-answer session. [Operator Instructions] And I see here that we have our first question from Aleksander Peterc at Societe Generale. Hello, Aleksander.

[François:]

[Bouvignies:]

[Peter Nyquist:]

Thanks Sandeep and thanks Börje and thanks Carl for good answers in this session. But before concluding, I just want to repeat what Börje said, that we will have the Capital Market Day in New York, December 15 and there will be possibilities to register upcoming week here for all of you that want to participate. So by that, thank you all for participating in today’s call.

[Börje:]

Thank you.

[Ekholm:]

Thank you.

[Carl Mellander:]

Thank you.