Thank you. Hello, 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. Ladies and gentlemen, when you'd like to ask a question, please press zero and then one on your push button phone. If you'd like to decline from the polling process, then just press zero and then two. As a reminder, replay will be available one hour after today's call. Peter Nyquist will now open the call. Please begin, sir.
Thank you, operator. Everybody, welcome to the second call for today for the Q2 report. With me here in the room, I have our President and CEO, Börje Ekholm, and our CFO, Carl Mellander. Before reading the statement, I just want to say that we going to shorten this and have only a few slides that we will present, and spend more of the time on the Q&A. Before that, I will read the statement. 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 risk and uncertainties. The actual result 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 you, Börje. Please, Börje.
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 on the way of reaching the targets in all segments that we have set for 2020 and 2022. 5G is gaining momentum around the world, and it's now launched in four continents. We're starting to see some very good pickup and good interest from consumers as well. We see some operators realizing a price premium for the premium services that 5G can give. Our focus strategy builds upon achieving technology leadership, and we're starting to see that the increased investments we have made in technology leadership come into 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 in millimeter wave. Today we are providing solutions to two-thirds of all commercially launched networks. We are moving now from a phase of being first, being fast on paper, into becoming leading in in-field performance. Here we feel we are making good progress. We see today also in all ongoing engagements with customers, we see 5G featuring very prominently, this has changed just from a few quarters ago. It is also clear that the first use case for 5G will be enhanced mobile broadband or is enhanced mobile broadband.
The real potential over time will be enterprise-driven use cases, where we build and leverage the capabilities 5G can give in terms of high speed, low latency, low battery consumption, many connections per surface units, et cetera. That will create all of those new use cases. We see sales growing organically by 7%, driven by networks in North America and Northeast Asia, That is, of course, the market that first launched 5G. Cash flow was SEK 2.2 billion in the second quarter, and that is after absorbing large conversion of provisions to cash. The last few years, actually Q2 has been negative Free Cash Flow, It is a bit of a milestone to also have a positive cash flow in Q2.
Our strategy builds upon being technology leaders, so we continue to invest in our 5G portfolio, both in radio, but also in the cloud-native Core portfolio and Digital Services. In addition, we are increasing our investments in R&D, in Managed Services in order to fundamentally change or improve the margin profile of the business. If we quickly look at the numbers, we see the reported sales was up 10% and organic was up 7%. Operating margin increased year-over-year, but was flat sequentially when you adjust for the one-time revenues during Q1. Networks saw good growth of 11%, driven by 5G traction and strategic contracts. Of course, we should remember the strategic contracts we take, because they have a bit of a margin hit up front, but strengthen our competitive position and are totally value creative during the contract life, but hurt us initially.
We have a number of those that are visible in the gross margin to limited effect in the second quarter but w e also have a large settlement on patents. That is also impacting gross margin in the second quarter. Digital Services is executing on the plan to reach single-digit margins for 2020. Losses are falling sequentially, and as we have said before, we should not expect the improvements to be linear. We see good traction in the turnaround and costs are coming out as planned. Gross margin fell year-over-year due to product mix as well as legacy portfolio, and with product mix, it is a lower software sales in the second quarter than last year. We are both seeing a number of positive signs. For example, our cloud-native offerings are gaining momentum.
We see that our new BSS strategy is also gaining traction with customers, where we see several new customers, as well as renewed engagement with existing customers. Overall, we see that Digital Services is progressing well towards low single-digit margins next year. Managed Services had flat sales if you adjust for the planned Constellix exit. Gross margin declined due to timing between quarters of cost, basically. Here we are taking some short-term cost as we increase R&D investment in order to drive our operations engine that builds upon automation and AI. Emerging Business is our area where we invest for new innovative solutions, and results here improved, driven by our profitable IoT connected business. As I said, Free Cash Flow is SEK 2.2 billion after having had SEK 3.7 billion in cash outlays for provisions and restructuring. Take the next.
We have gotten quite a lot of questions about the gross margin development. You can see from this graph that we have a sequential decline in gross margin which is, when you look quarter-over-quarter, the deepest is really due to a couple of reasons. One is, of course, that we had larger than usual IPR revenues during the first quarter which helped gross margin and gave a boost on gross margin. While we in the second quarter have a large IPR settlement, of course, putting pressure on gross margin in Q2. We have some other effects on a little bit lower software portion in Digital Services and some timing of cost in Managed Services. If we leave that a bit outside and jump to the next slide, which is focusing on the movements in Networks.
If we look at the Q1 gross margin, it was 43.2%. What we have here is an unseasonably large IPR revenues in Q1, which, of course, then can relate a bit to some old con or catch-up payments on old contracts. If you remove that, you get to an adjusted Q1 margin, and given that we haven't given the detailed numbers here, we can look at the size of the bars and kind of estimate them but they are not populated with numbers. I'll go back to that later. The Adjusted Q1 margin then comes back a little bit lower. If you look at Q2, it is reported 41.4%. We have a license settlement, basically a patent dispute that we settled which hurt the short-term margins.
If you look there, if you will put them in numbers, just to give you a size comparison, the license settlement is about 1%. It would be about 42.4%, and the IPR revenue delta Q1 to Q2 is about 0.6%. If you were to look at the underlying change in gross margin, it's about 0.2%. That 0.2% is actually the impact of strategic contracts and operating leverage. What we're trying to say here is we use part of the operating leverage to invest in the strategic contracts, and the strategic contracts will be somewhat more during the second half than during Q2. We don't see a diminished operating leverage. The whole notion here is we will manage the overall P&L statement but we are going to have some of these one-time effects on IPR revenues that will vary by quarter.
Of course, it's very hard for us to predict when we have a license settlement to be honest, on either revenue side or outflow side. That's why you see the underlying gross margin quarter-over-quarter shows a very little and very small delta, about 0.2%. Okay. Good. We stop there for a while, and we can come back to closing remarks from Börje later on. Now I would like to hand over to the operator again and for question and answers. Please, operator.
Thanks.
Ladies and gentlemen, if you wish to ask a question and you haven't already, just press zero and then one on your phone keypad now in order to enter the queue. Then after I announce you, just ask that question. If you find that question has been answered before it's your turn to speak, just press zero and then two to cancel. 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. For the first one, we go to the line of Ed Snyder at Charter Equity Research. Please go ahead.
Hi, Ed.
Thank you very much. Good morning, or afternoon as it is. A question on your strength in North America. I know we've talked about this at length before, and you've mentioned 5G and different variants of it. If we could maybe get a high-level view, is the vast majority of that due to 5G build-out? Are you seeing capacity expansions in 4G? To the extent it is 5G, is it mostly millimeter wave or the low bands?
To get into that would also start to disclose different strategies for different of our customers. We're not going to do that. What I will say is that we see a lot of capacity expansion in North America. That is clearly the most important part. Of course, we see as well 5G deployments and that's why there is a significant growth.
Great. Thank you. Then as you stated, both this call and last call, that 5G will probably be more about enterprise and private networks than just raw consumer demand. 4G, we saw big capacity expansions in consumer demand, then 5G, I know you mentioned initially mobile broadband but that it would be followed by, like I said, enterprise and private client. Nokia's essentially said about the same thing. Isn't that a fundamental change in the addressable market from like a mass market horizontal product to more of a vertical? As a result, shouldn't we see some sort of variation on the profile of your revenue, say higher gross margin but lower growth given vertical's going to go slower, but you've got better pricing power?
We're still so early in this development. What is clear is that connectivity in the enterprise sector is increasingly important. Wireless connectivity that is reliable and secure is very hard to get unless on your own licensed spectrum. We see a increasing interest from enterprises, we see that with our partnerships, we just recently for example, had a big win in Germany, with a automotive company. We are seeing this to change the fundamentals of the business. The way we think about it is that we have a consumer business, just as you said. That's the bread and butter. 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.
Would you anticipate any? Yeah. Thank you. I guess the last question related to that is, given the emergence of the enterprise as more of a private client network, do you see any change in revenue profile at all? I understand it's small, it hasn't gotten large at this point, shouldn't we naturally expect some difference in the profile of the revenue, either the revenue growth or the margins or how it evolves?
I think it's a bit speculative yet but what you are likely to see is larger share hardware, software with a better gross margin than service revenues. Less of the rollout revenue, call it that. Where that is ultimately going to end up is too early to tell.
Thank you.
Operator, we are ready for the next question.
Thank you. That's over to the line of Alex Duval at Goldman Sachs. Please go ahead, your line is now open.
Hi, Alex.
Yes. Hi, everyone. Hi. Thank you for the question. Firstly, just wanted to ask on your Free Cash Flow, which seemed especially strong in the quarter, particularly when you factor in provisions you've been taking. Wondered 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 of the other drivers of that would be interesting. Second of all, there were 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 specific 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.
Should I take cash flow first? Hi, Alex. If we break it down a bit, you're right to say that the majority of the improvement here comes from the improved profit as such. If we look at working capital then, given the high business activity we have, we see some build up in the quarter of inventory, and that's followed to some extent by payables as well because it goes together often with inventory build up as well, because it's sourced obviously from third parties to a large extent. What's a good part here in working capital also was trade receivables or accounts receivables which came down following good collections in the quarter.
I think that pretty much summarizes the most important points there, that generated and as Börje said before, this positive cash flow of SEK 2.2, which we haven't really seen in a second quarter for a long time. Also looking at year to date, we are SEK 5.7 billion better than 2018.
Okay, market share?
Market share. So far in China, we're very early in the 5G cycle, so it's a little bit too early to have a firm view. What we are clearly aiming for is that we would have a stronger market share in 5G than in 4G. We have invested for that and conducted field trials for that. We will have to see and make sure that we're 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. That's where we are right now.
That's great.
I think we can also say, it's always a bit hard to know exactly what the macro data will show once they come, so we will see that. We believe that we have a very competitive offering and that we are gaining market share in several geographies.
Many thanks.
Okay, Alex, you happy?
That's great. Many thanks.
Okay, we're now over to the line, Sandeep Deshpande at JPMorgan. Please go ahead. Your line is open.
Yeah. Hi. Thanks for letting me on. I have a question on 5G. How do you think, Börje, that 5G is going to be different from the 4G rollout? Initially, as you said, that it is being used as a capacity addition, in terms of technology in a few areas. Is this going to become a mainstream coverage technology at some point? Does this rollout continue for a multiple quarter or multiple year period, and particularly in some of these early markets such as the United States, Korea, Japan, et cetera? Is this going to be a point technology?
We actually ultimately think all frequency bands will be 5G enabled, which means all operators want to leverage the full spectrum portfolio and the full coverage. That's what's ultimately going to provide the long-term value of 5G. Even when you talk about a factory connectivity, it's very interesting that when we talk to industrial companies, yes, they're interested in the indoor coverage and providing that in an undisturbed and with a very high degree of reliability. They're equally interested in having it connected to the outside world. Yes, I do think there are going to be initial deployments that are point driven, where you benefit the 5G characteristics but ultimately it's going to be connected to a broader macro network as well.
The way we think about this is that it will be a, in a way, similar type of build-out over time as you see with 4G. That's going to clearly take a time, and it's going to be focused initially on where you have big capacity needs and big industrial applications. Did I answer your questions?
Yes. Börje, just a follow-up to that would be, does that mean, based on what you're saying, that you see, given that you're seeing such a strong up cycle in terms of your revenue growth in Networks this year, that this could be a multi-year process?
Yes, we do believe that the technology cycle is both going to go faster than historic cycles and probably last a bit longer. The reason for that is the base business is going to be consumer business, but we also see a big growth potential in the enterprise area. Networks are going to be built out first for consumer but ultimately for enterprise. That's why we're rather optimistic of the long-term outlook of the need for 5G technology.
Thank you.
We're open for next question, please.
Operator, we're ready for the next question.
Yes. The next question is over the line of Simon Leopold at Raymond James. Please go ahead. Your line is now open.
Hello, Simon.
Great. Thank you for taking the question. I wanted to drill down on the Northeast Asia region. Specifically, want to understand what your assumptions are in terms of the timing for the China 5G. The question is rooted in the potential that maybe given the trade tensions between the U.S. and China, that maybe some of the project activity slides out in time. I want to understand what you're thinking about that. 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.
I'll start by China, I can comment on that. We have said that we believe large scale deployments will be 2020. We will see some emerging deployments in the second half.
That is still the best judgment we have. I think it is fair to say what the trade tensions, geopolitical uncertainty, et cetera, will bring is very hard to speculate on. If that impacts, we really don't know right now. We plan for seeing bigger deployments in 2020.
We're also seeing, of course, we're a participant in the 5G roll-outs in Korea, and that's been going on for some time. We have networks there as well in mid-band. That is clearly one of the key reasons why the region actually grows. We have not yet seen major deployments in Japan. On the other hand, operators there have just been given spectrum and are in the process of gearing up. Tokyo Olympics, I'm sure will help, once that comes. I think we're going to see a good development there, as they also build out 5G to capture the opportunities. 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.
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?
They are sizable markets. We don't provide you with a breakdown of the countries. Except that we have said that, I believe Korea is a top five market right now.
You can see that. Quality, it's about 4% or so of top line.
Great. Thank you for taking the question.
That can expand the size then of Japan once it's in fuller swing.
Yep. Thank you.
Thank you.
We are now over to the line of Achal Sultania at Credit Suisse. Please go ahead, sir, your line is now open.
Hi. Thanks for taking my question. On media solutions, I see that you still have an operating loss of SEK 200 million in the quarter. I thought that this was already deconsolidated, from the business after the divestment. Can you help us understand why that number is a loss still, and should we expect that to continue in the second half? Secondly, on the gross margin, again. Börje, obviously, thanks for explaining the moving parts in the gross margin. 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 these strategic contracts, some of which you said was partly 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. The headwind probably accelerates. Equally, are there any other positive moving parts for gross margins that we should also think about going into the second half?
Should I take the MediaKind? Yeah, you can take the MediaKind. Achal, hi. You're right. It's coming in now. The MediaKind investment is at 49% of earnings. It comes on the line, share of earnings in joint ventures and associated companies. You're right, there was a loss then in 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.
Sorry, just to clarify, Carl. The SEK 200 million loss is 49% of the total loss is equal to SEK 200 million loss that you report?
Majority of that, yeah.
Okay.
Unfortunately, costs are higher than revenues in that business s o far but t he intention is that it clearly would 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. So you can see somewhat more than the 20 basis points, but not dramatically more.
Okay. Thank you. Thank you, Börje.
Yeah. Thanks.
The next question, please.
Is over to the line of Richard Kramer at Arete Research. Please go ahead. Your line is open.
Thank you very much. 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. Can 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? Could that be as the North America market starts to normalize 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? Second, if we step back from these quarter's moves in gross margins and Networks, and we remove the IPR income from both Network sales and margins over the last year and a half, your Core Networks business margin seems to be around 10 or 11%, roughly.
Given that nearly all of those network sales come from telcos, is that the sort of peak or reasonable margin you can expect in negotiations with what are very large customers and obviously now very well accustomed to long-term procurement and how much margin they leave on the table for their vendors or do you see material upside beyond your near-term targets to try to get more margin out of those telco customers? Thanks.
If we start with the first one, what we see, what we're trying to say is that you see a larger service portion in the second half. Of course that is helping, or hurting gross margins in the second half in North America. I would caution you to say that we have multiple geographies with similar margin profiles as North America. 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, the knowledge from before may not be as relevant. That's the one thing. The other is, if you look at guidance for the second half, yes, we say that North America is running at a very high rate, and we don't see the same growth rate continuing.
We also see an increasing service portion in the second part. That is going to bear on gross margins a bit. Overall, we're not trying to say that gross margin second half is in any way dramatically deviating from the guidance we've given.
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 been exclusively focused on the consumer business. We see that that is changing into becoming an enterprise business, that's why it's a little bit speculative to think about how the margin profile is going to look longer term. Are you happy?
Yeah. Thank you.
We will continue to the next question, please.
Okay, the next question is over the line of Stefan Slowinski of Exane BNP Paribas. Please go ahead.
Hello, Stefan. Welcome back.
Hi. Sorry to belabor on the margin, on the gross margin, you've kind of quantified here with that new slide the 20 basis points of sequential impact, kind of 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 sort of continue into 2020 on the strategic project front o r should we expect that to kind of run its course? Obviously, there will be other puts and takes on the margin in 2020 in terms of geographic contribution and business mix. From a strategic project standpoint, that kind of 20 basis point headwind that you just talked about, and will that continue into next year, or is that something that will go away? Thank you.
Our view of the reason why we take those is to position ourselves for 5G. We are, of course, taking those contracts in the knowledge of the impact of those are not going to be with us on the negative front for more than a few quarters. We are surely going to deliver on some of the strategic contracts in 2020. Think of it as the operating leverage remains, the negative part dissipates. If you 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.
Got it. Thank you.
You got it. Thank you. We're actually open for the last question of this session. Please, operator.
Yes, of course. The last question for today's call is over to the line of Tal Liani at Bank of America. Thank you very much. Your line is open.
Thank you. This is Tal from Bank of America. I have two questions. The first one 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? Second, can you elaborate on the advantages versus Nokia technology, et cetera? Second question is about North America. What happens if there are delays in allocating spectrum on the 3.5 GHz 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 millimeter wave to continue and grow for a few years? Thanks.
We don't comment on competitors, and we're here with Ericsson, that's my focus, and if they want to comment, they can do it but I'm not going to do it. 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 release spectrum. That would help for a national rollout perspective. From our demand perspective, we think the current type of spectrum will drive the current type of build-out, 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.
Got it. If I can go back mainly to my first question and ask it more in general, not versus a specific competitor. What drives your share gains? Do you think you have a sustainable technical advantage that can take you to sustainable share gains over the next few years o r did you just have a head start versus competitors and this is why we're seeing strong performance now, and do you expect it to even out in the next few quarters?
We took the steps to invest in making our technology leadership to make our portfolio competitive. That's in order to invest to stay ahead. It's to drive new innovation, new spectrum utilization technologies, and create that as a sustainable advantage versus competition. It's like in most technology areas, they will be where we are at some point in time but then we have also moved ahead. It's increasingly difficult to catch up, for example, on dynamic spectrum sharing that we can do on our baseband from 2015 and onwards. Of course, for our customers like Swisscom in Switzerland, they can actually achieve 90% population coverage by year-end by leveraging our infrastructure. That's of course not doable unless you have a technology leadership mindset and continuously investing in technology. That's what we are intending to do.
The other part here is actually to get the continuous cost cadence. By introducing new platforms and new technologies, we can bring the cost down on our equipment. It's a kind of a double whammy where we get the product benefit as well as cost benefit helping us, and that's what you see in the gross margin expansion during 2018. It's really those two factors coming through.
Got it. Thank you.
Thank you. With that.
Before we close this, maybe you want to have the last remark?
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 and predominantly Northeast Asia and North America. We saw profitability negatively impacted by IPR contracts and IPR swings versus Q1. We continue to execute on the plan in Digital Services to gradually and sequentially 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 of costs, but we see that our investments in automation and machine learning starting to pay off in operations ending that's longer term going to drive a very different margin profile. Emerging Business saw good growth driven by our profitable IoT connected business.
We are overall confident in reaching the targets we set out for 2020 as well as 2022. Again, thank you for listening to the Q2 report.
Thank you. Goodbye.