Telefonaktiebolaget LM Ericsson (publ)
Q2 2019 Earnings Call Transcript

Published: 17 Jul 2019

[Operator:]

Thank you. Hello and welcome to Ericsson's Analyst and Media Call for their Second Quarter report. To view visual aids for this call, please log on to www.ericsson.com/press or www.ericsson.com/investors. [Operator Instructions]. And as a reminder, a replay will be available one hour after today's call.Peter Nyquist will now open the call. Please begin, sir.

[Peter Nyquist:]

Thank you, operator, and everybody welcome to the second quarter call today for the Q2 report. With me here in the room are President and CEO, Börje Ekholm; and our CFO, Carl Mellander.Before reading the statement, I just want to say that we’re going to shorten this on the few slides that we will present and spend more of the time on the Q&A. But before that I will read the statements. During the call today we will be making forward-looking statements. These statements are based on our current expectations 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 all to read about these risks and uncertainties in our earnings call as well as in our annual report.With that said, I would like to hand over the word to Börje. So please go ahead.

[Börje Ekholm:]

Thank you, Mr. Nyquist, and welcome to this second quarter presentation that showed another quarter of stable development and on our turnaround plan putting us well underway of reaching the targets in all segments by -- that we have set for 2020 and 2022.5G is gaining momentum around the world and it's now launched worst in four continents. And we're starting to see some very good pickup and good interest from consumers as well. And we see some operators realizing a price premium for their premium services that 5G can give.Our strategy -- our focused strategy is being just on achieving technology leadership, and we're starting to see that the increased investments we have made in technology leadership coming to fruition in increased competitiveness as well as improved gross margin.Today, we have a very competitive portfolio across RAN and core. As you know our priority is to work with lead customers in lead markets and this has allowed us now to launch commercial service in mid-band as well as a millimeter wave. And today we are providing solutions to two-thirds of our commercially launched networks. And we're moving now from a phase of being

[Peter Nyquist:]

Good. We’ll stop there for a while and we can come back to closing remarks from Börje later on. But now I would like to hand over to the operator again for questions-and-answers.

[Operator:]

[Operator Instructions]. And as always, please limit yourself to one question at a time and please keep your questions at a broad level. Detailed information is provided in the report. And Ericsson’s Investor Relations and media relations teams will be happy to take additional questions and discuss any further details with you after the call.And so for first one, we’ll go to the line of Ed Snyder of Charter Equity Research. Please go ahead.

[Ed Snyder:]

A question on your strength in North America. I know we've talked about this at length before you've mentioned 5G in different variants of it. But if we could maybe get a high level view, is the vast majority of that due to 5G build-up? Are you seeing capacity expansions in 4G? And to the extent if it’s 5G, is it mostly millimeter wave or the low-bands?

[Börje Ekholm:]

To get into that we would also start to disclose different strategies for different of our customers. So we're not going to do that. But what I will say is that we see a lot of capacity expansion in North America. And that is clearly the most important part. But of course we see as well 5G deployments. And that's why there is a significant growth.

[Ed Snyder:]

And then as you see that -- Börje you said on the last call that 5G was probably more about enterprise and private networks and just raw consumer demand. So 4G we saw big capacity expansions and consumer demand. And in 5G, I know you mentioned initially mobile broadband, but that would be followed by like you said enterprise and private client. And Nokia has essentially said about same thing. Isn't that a fundamental change in the addressable market from like a mass market horizontal product to more of a vertical? And as a result, should we see some sort of variation on the profile of your revenues say higher gross margin but lower growth given vertical spending goes slower, but you've got better pricing power?

[Börje Ekholm:]

We're still so early in this development. But what this clear is that connectivity in the enterprise sector is increasingly important. And wireless connectivity that is reliable and secure, it’s very hard to get on this when you’re on licensed spectrum. So we see a increasing interest from enterprises and we see that with our partnerships and we just recently for example had a big one in Germany with a automotive company. So we are seeing the sort of changed fundamentals of the business. So the way we think about it is that we have a consumer base itself, as you said, that's the bread and butter. But on top of that, we are starting to see a enterprise segment emerging. But it's still too early to talk about it as a big market. It's just in its infancy.

[Ed Snyder:]

Thank you. And I guess the last question related to that is, given the emergence of the enterprise is more of a private client network, do you see any change in revenue profile at all? I understand it’s small and hasn’t gotten large at this point. But should we naturally expect some difference in the profile, the revenue -- either the revenue growth, the margins or how it evolves?

[Börje Ekholm:]

I think we -- it’s a big speculative, yes, but what you're likely to see is a larger share of hardware and software with a better gross margin than service revenues. Let -- so they’re very large revenues, call it that. So, where they are ultimately going to end up is too early to tell.

[Peter Nyquist:]

So operator, we are ready for the next question.

[Operator:]

Thank you. And that's comes from the line of Al Duval at Goldman Sachs. Please go ahead. Your line is now open.

[Al Duval:]

Firstly just want to ask on your free cash flow which seemed especially strong in the quarter and strictly manufacturing provision we've been taking. So one, if you could talk us through the moving parts there of that improvement and how sustainable that is? Obviously, you talked about profitability, but any other drivers of that would be interesting?Second, there was some news reports in the last month or two about Ericsson's market share, one of the Chinese telcos going up significantly. I realize you can’t talk about significant customers, but wondered if you could just talk about the broader situation in markets like China, and how you feel about your competitive positioning and opportunities?

[Börje Ekholm:]

Should I take cash flow first?

[Carl Mellander:]

Hi, Alex. So if we break it down a bit, and you’re right to say that the majority of the improvement there comes from the improved profit as such. But if we look at working capital and given the high business activity we have, we see some buildup in the quarter of inventory. And that followed to some extent by payables as well because it goes together often with inventory buildup as well because it’s sourced obviously from third-party to a large extent.But what a good part here in working capital also was trade receivables or accounts receivables which came down following good collections in the quarter. So I think that pretty much summarizes the most important point and that’s generated and as Börje said before, there’s positive cash flow of SEK 2.2 billion which we haven't really seen in the second quarter for a long time. And also looking at year-to-date we are at 5.7 billion investor than 2018.

[Al Duval:]

Okay. Then market share?

[Börje Ekholm:]

Market share, it is -- so far in China we're very early in the 5G cycle. So it’s a little bit too early to have a current view. What we're clearly aiming for is that we would have a stronger market share in 5G than in 4G and we have invested for that and conducted team trials for that. But we will really have to see and make sure that we are competitive to see that we end up there. We will know a lot more in the next few months and then we can talk more about it, but that’s where we are right now. It's always a bit hard to know exactly what the macro data will show on the account, so we will see that. But we believe that we have a very competitive offering and that we are gaining market share in several geographies.

[Operator:]

Okay. We're now over to the line of Sandeep Deshpande of JPMorgan. Please go ahead. Your line is now open.

[Sandeep Deshpande:]

I have a question on 5G. How do you think that 5G is going to be different from the 4G rollout because initially as you said there is being used as a capacity addition in terms of technology in a few areas, but is this going to become a mainstream coverage technology at some point and does this rollout continue for a multiple quarter or multiple year period particularly in some of these early markets such as United States, Korea, Japan et cetera or is this going to be a point technology?

[Börje Ekholm:]

We actually ultimately think all frequency bands will be 5G enabled, which means all operators want to leverage their full spectrum portfolio and their full quality and their full coverage and that’s what’s ultimately going to provide the long-term value of 5G. So even when you talk about a factory connectivity, it’s very interesting that when we talk to industrial companies, yes they are interested in the indoor coverage and providing that in a undisturbed and with a very high degree of reliability but they are equally interested in having it connected to the outside world.So yes I do think there are going to be initial deployments that are call it point treatment of where you’ve have been if it’s a 5G characteristics but ultimately it’s going to be connected to a broader macro network as well. So the way we think about this is that it will be a -- in a ways similar type of build-out over time as you see with 4G. But that’s kind of okay, it will take the time and it’s going to be focused initially on where you the capacity needs and big industrial applications. Did I answer your questions?

[Sandeep Deshpande:]

Yes. But just a follow up to that would be, so does that mean basically what you're seeing that see -- given that you are seeing such a strong upcycle in terms of your revenue growth in networks this year, that this could be a multiyear process?

[Börje Ekholm:]

We are not going to get into guidance but yes we do believe that the technology cycle is both going to go faster than historic cycles and probably last a bit longer. And the reason for that is that this is going to be consumer business but we also see a big growth potential in the enterprise area. So, networks are going to be built out first for consumers but ultimately for enterprises. And that's why we're rather optimistic of the long-term outlook of the need for 5G technology.Can we go to the next question, please?

[Peter Nyquist:]

Operator, we’re ready for the next question.

[Operator:]

Yes. The next question is from the line of Simon Leopold of Raymond James. Please go ahead. Your line is now open.

[Simon Leopold:]

Great. Thank you. Thank you for taking the question. I wanted to drill down on the Northeast Asia region. Specifically I want to understand what your assumptions are in terms of the timing for the China 5G. And the question is rooted in the potential that maybe be given the trade tensions between the U.S. and China that that maybe some of the project activity slides out in time. So I want to understand what you're thinking about that? And then also within the Northeast Asia region, I want to get a better understanding of the materiality of your business outside of China, specifically South Korea, Japan, which I'm assuming are included in that region? Thank you.

[Börje Ekholm:]

Let me start by China and I can comment on that. We have said that we believe large scale deployments will be 2020. But we will see some emerging deployments in the second half. That is still the best judgment we have. And I think it is fair to say both the trade tensions, geopolitical uncertainty et cetera is very hard to speculate on. And so that impact we really don't know right now, but we plan for seeing bigger deployments in 2020.We're also seeing of course the -- we are participant in 5G rollout in Korea. And that's been going on for some time. And so we have networks as well in mid-band. So that is clearly one of the key reasons why the region actually grows. We have not yet seen major deployments in Japan. But on the other hand, operators there are adjusting given spectrum and are in the process of gearing up. So, Tokyo Olympics, I'm sure, will help once that comes. So, I think we're going to see a good development there as they also build out 5G to capture the opportunity. So, overall, we're quite excited about the prospects in Northeast Asia, as we see that that is a leading technology region as well as investment region.

[Simon Leopold:]

And how big have Korea and Japan been, in general, within the business overall? Are they combined low single-digit percent, or is that too low an estimate?

[Börje Ekholm:]

They are sizable markets. We don't provide you with a breakdown of the countries, so -- except that we have said that I believe Korea is a top five market right now. So, you can see that -- it's about 4% or so --

[Carl Mellander:]

Of top-line …

[Börje Ekholm:]

Of top-line …

[Simon Leopold:]

Great. Thank you for taking the question.

[Börje Ekholm:]

.. size then of Japan once it's in the fuller swing.

[Operator:]

We are now over to the line of Achal Sultania at Credit Suisse. Please go ahead, sir. Your line is now open.

[Achal Sultania:]

So, on media solutions, I see that you still have an operating loss of a couple of hundred million krona in the quarter. I thought that this was all to be consolidated from the business after the divestment. So, can you help us understand that -- why that number is a loss still and should we expect that to continue in the second half? And then, secondly, on the gross margin, again -- so, Börje, obviously, thank you for explaining the moving parts in the gross margin. So, the way I think about it going forward is, you had about 20 basis points of hit in your gross margins in networks business due to the strategic contracts, some of which you said was partially offset by operating leverage.I guess, as we move into the second half of the year, you probably expect more of these contracts to ramp up. So, the headwind probably accelerates. But then, equally, are there any other positive moving parts for gross margins that we should also think about going into the second half?

[Carl Mellander:]

You're right. This is coming in now. The MediaKind investment is 49% of earnings. It comes on the line share of earnings in the joint ventures and associated companies. And you're right, that was a loss on the company and we get 49% of that. We're not guiding specifically on how that will develop. Obviously, the intention of the two shareholders is to improve on this business and turn it around as well.

[Achal Sultania:]

So, just to clarify, Carl. So, the SEK 200 million loss is -- 49% of the total loss is equal to SEK 200 million loss that you report.

[Carl Mellander:]

Majority of that, yes.

[Achal Sultania:]

Okay.

[Börje Ekholm:]

Unfortunately, costs are higher than revenues in that business. And -- so far. But the intention is that clearly it will improve. On the gross margin, yes, the net effect of operating leverage and strategic contracts are about 20 basis points for the second quarter. We expect the operating leverage to continue and be significant in the business, but we also say that we're using part of the operating leverage to actually reinvest in some of these strategic contracts, or important contracts. And that -- so, you can see somewhat more than the 20 basis points, but not dramatically more.

[Peter Nyquist:]

So, the next question, please?

[Operator:]

Is over to the line of Richard Kramer at Arete Research. Please go ahead. Your line is open.

[Richard Kramer:]

My two questions are -- first of all, if we look at the portion of sales in North America, especially in networks, it remains very high. And you talk a little bit about the difference in gross margins that have long been understood to be much higher in the North American market than in other markets. And could that be, as the North America market starts to immortalize from the big 5G rollouts that we see now -- could that be part of your thinking around second half gross margins or potentially gross margins next year?And second, if we step back from these quarters' moves in gross margins and networks, and we remove the IPR income from both network sales and margins over the last years and a half, your core networks business margin seems to be around 10% or 11%, roughly. And given that nearly all of those network sales come from telcos, is that the peak or reasonable margin you can expect in negotiations with what are very large customers and, obviously, now very well accustomed to a long-term procurement and how much margin they leave on the table for their vendors. Or do you see material outside beyond your near-term targets to try to get more margin out of those telco customers? Thanks.

[Börje Ekholm:]

If we start with the first one, what we see is -- what you're trying to say is that you see a larger service portion in the second half. And of course, that is helping -- hurting gross margins in the second half in North America. But I would caution you to say that it's -- we have multiple geographies with similar margin profiles as North America. So, the dependence in our current structure is less than it might have been understood to have been historically. I know I made that point to you a bit earlier also, but that is unfortunately the fact, and the knowledge from before may not be as relevant. So, that's the one thing.The other is, if you look at the guidance for the second half, yes we say that North America is running at the very high rate and we don't see the same growth rate continuing. But we do -- we also see an increase in service portion in the second part that is going to bear on gross margins a bit. But overall, we're not trying to say that gross margin second half is in any way dramatically deviating from the guidance we've given. So, we're not trying to give a profit warning in any way on that. If you look longer term, I do think that the interesting part here is so far the business being exclusively focused on the consumer business. We see that that is changing into becoming an enterprise business, and that's why it's a little bit speculative to think about how the margin profile is going to look longer term. Did it help you?

[Peter Nyquist:]

And we will continue to take next question, please.

[Operator:]

Okay, the next question is of the line of Stefan Slowinski of Exane BNP Paribas. Please go ahead.

[Peter Nyquist:]

Hello, Stefan.

[Stefan Slowinski:]

Sorry to belabor on the margin, but on the gross margin you've quantified here with that new slide the 20 basis points of sequential impact -- the net of the operating leverage and the strategic projects headwind. Understanding the second half, maybe there's a slight more of a headwind on the strategic project side. I guess the question is, does that continue into 2020 on the strategic project front, or should we expect that to run its course? Obviously, there will be other puts and takes on the margin in 2020 in terms of geographic contribution and business mix. But from a strategic project standpoint, that 20 basis point headwind that you just talked about, will that continue into next year or is that something that will go away? Thank you.

[Börje Ekholm:]

I mean, they will -- our view of -- the reason why we take those is to position ourselves for 5G. So, we are, of course, taking those contracts in the knowledge of -- that's not the -- the impact of those are not going to be with us on the negative front for more than a few quarters. So, we are surely going to deliver on some of the strategic contracts in 2020. But think of it as the operating leverage remains, but the negative part dissipates. So, if you're -- would make that, there is an underlying improvement that today is not visible because we reinvested in strategic contracts. That underlying improvement will start to become visible. And that will happen into 2020.

[Peter Nyquist:]

You got it? Thank you. Then, we're actually open for the last question of this session. So, please, operator?

[Operator:]

Yes, of course the last question for today's call is over to the line of Damian Leoni at Bank of America. Thank you very much. Your line is open.

[Tal Liani:]

This is Tal from Bank of America. I have two questions. The one first is, we spoke about market share versus Huawei, but you didn't speak about market share movement versus Nokia. How do you see them in the market? And second, can you elaborate on the advantages versus Nokia technology, etc.? Second question is about North America. What happens if there are delays in allocating spectrum on the 3.5 gig in North America? Do you expect 5G to slow down waiting for Spectrum? Or is there enough juice, if I can call it, in low band and minimum wage to continue and grow for a few years? Thanks.A - Börje EkholmYes, we don't comment on competitors and that's -- we're here with Ericsson. That's my focus. If they want to comment, they can do it, but I'm not going to do it. On the -- if you look in the U.S., yes, there is a lack of mid band spectrum. That's quite clear. There are many trusts ongoing on how to relieve spectrum. That would help for national load perspective. But from our demand perspective, we think we're -- the current kind of spectrum will drive the current type of buildout. So, we don't see that to impact dramatically, actually, for us -- in the near-term, I should say. Longer term, we need the mid band in order to capitalize on new opportunities for 5G and new use cases for 5G.

[Tal Liani:]

Got it. So, if I can go back maybe to my first question and ask it more in general, not versus a specific competitor? What drives your share gains? Do you have -- do you think have a sustainable technical advantage that can take to your sustainable share gains over the next few years or did you just have a head start versus competitors and this is why we're seeing strong performance? And do you expect it to even out in the next few quarters?

[Börje Ekholm:]

We took the steps to invest in making our -- technology leadership to make our portfolio competitive. And that's in order to invest -- to stay ahead so as to drive new innovation, new spectrum utilization technologies, and create that as a sustainable advantage versus competition. The -- it's like in most technology areas, there will -- they will be where we are at some point in time. But then, we have also moved ahead. So, it's increasingly difficult to catch up, for example, on dynamic spectrum sharing that we can do on our base band from 2015 and onwards. So, of course, for our customers, like COMMON Switzerland, they can actually achieve 90% population coverage by year-end, but leveraging our infrastructure. And that's, of course, not doable unless you have a technology leadership mindset and continuously investing in technology. And that's' what we are intending to do.The other part here is actually to get the continuous cost cadence. So, by introducing new platforms and new technologies, we can bring the cost down on our equipment. And that's makes -- it's a double whammy, where we get the product benefit as well as cost benefit helping us. And then, that's what you see in the gross margin expansion during 2018. It's really those two factors coming through.

[Peter Nyquist:]

So, by that -- before we close this, Börje, you want to have the last remark?

[Börje Ekholm:]

No, I want to just thank you for listening in. We are continuing to invest for technology leadership that will help us drive, of course, market position and competitiveness, but also our cost position. We saw a second quarter with solid growth, driven by networks in predominantly Northeast Asia and North America. We saw profitability negatively impacted by IPR contract and IPR swings versus Q1. We continue to execute on the plan in digital services to gradually and sequentially profit, or lower the loss, turning that into a profitable business next year.Managed Services has a bit of a lower margin in second quarter due to timing or costs. But we see that our investments in automation and machine learning is starting to pay off in operations ending. That's longer term going to drive a very different margin profile. Emerging business saw a good growth, driven by our profitable AI connective business. So, we are overall confident in reaching the targets we set out for 2020 as well as 2022. So, again, thank you for listening to the Q2 report.

[Peter Nyquist:]

Thank you. Goodbye.