Earnings Call: Q2 2019

Jul 17, 2019

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.erickson.com/pressorwww.erickson.com /investors. Peter Nykavist will now open the call. Please begin, sir. Thank you, operator, and everybody, welcome to the second call for today for the Q2 report. With me here in the room, I have our President and CEO, Borje Ekholm and our CFO, Karl Melander. Before reading the statement, I just want to say that we're going to shorten this and have only a few slides that we will present and spend more of the time on the Q and A. But before that, I will read these statements. During the call today, 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 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, Borje. So please, Borje? 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 2022. 5 gs is gaining momentum around the world, and it's now launched in 4 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 the premium services that 5 gs can give. Our strategy, our focus strategy builds upon 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 in millimeter wave. And today, we are providing solutions to twothree of all commercially launched networks. And we're moving now from a phase of being first, and being fast on paper into becoming leading in infield performance. And here, we feel we are making good progress. We see today also in all ongoing engagements with customers, we see 5 gs featuring very prominently, and this has changed just from a few quarters ago. It is also clear that the first use case for 5 gs will be enhanced mobile broadband or is enhanced mobile broadband, But the real potential over time will be enterprise driven use cases, where we build and leverage the capabilities 5 gs can give in terms of high speed, low latency, low battery consumption, many connections per service units, etcetera. That will create all of those new use cases. We see organic or sales growing organically by 7%, driven by networks in North America and Northeast Asia. And that's, of course, the market that first launched 5 gs. Cash flow was SEK 2,200,000,000 in the second quarter, and that's after absorbing large commercial provisions to cash. The last few years, actually, Q2 has been negative free cash flow. So 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 5 gs portfolio, both in radio but in the cloud native core portfolio in digital services. But in addition, we are increasing our investments in R and D and managed services in order to fundamentally change the or improve the margin profile of the business. So 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 onetime revenues during Q1. Networks, good growth of 11%, driven by 5 gs traction and strategic contract. Of course, a portion of the and we should remember, the strategic contracts we take because they but they have a bit of a margin hit upfront, but strengthen our competitive position and are totally value created during the contract life, but hurt us initially. We have a number of those that are visible in the gross margin to a limited effect in the Q2. But we also have a large settlement on patents that is also impacting gross margin in the second quarter. Business 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. But 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's a lower software sales in the Q2 than last year. We are, though, seeing a number of 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. So 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 contract exits. Gross margin declined due to timing between cost as we increase R and D investments 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 Iconnective business. And as I said, free cash flow is EUR 2,200,000,000 after having had EUR 3,700,000,000 in cash outlays for provisions and restructuring. Take the next. We have gotten quite a lot of questions about the gross margin development. And you can see from this graph that we have a sequential decline in gross margin, which is when you look quarter over quarter, the dip is really due to a couple of reasons. One is, of course, that we had larger than usual IPR revenues during the Q1, 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. And then we have some other effects on a little bit lower software portion in digital services and some timing of costs in managed services. But 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 or catch up payments on old contracts. And that if you remove that, you get to an adjusted Q1 margin. And we 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. But and that is actually due to the I'll go back to that later. But 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. So if you look there if you would put them in numbers, just to give you a size comparison, the license settlement is about 1%. And the so it would be about 42.4%. And the IPO revenue delta delta Q1 to Q2 is about 0.6%. So if you were to look at the underlying change in gross margin, it's about 0.2%. And that 0.2% is actually the impact of strategic contracts and operating leverage. So what we're trying to say here is we use part of the operating leverage to invest in the strategic contracts. And the strategic contract will be somewhat more during the second half than during Q2. But we don't see a diminished operating leverage. So the whole notion here is we will manage the overall P and L statement, but we are going to have some of these onetime effects on IPR revenues that will vary by quarter. And 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. But 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 stopped there for a while and we can come back to closing remarks from Borje later on. But now I would like to hand over to the operator again and for question and answers. So please 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 the first one, we go to the line of Ed Schneider 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 5 gs and different variants of it. But if we could maybe get a high level view, is the vast majority of that due to 5 gs build out? Are you seeing capacity expansions in 4 gs? And to the extent it is 5 gs, is it mostly millimeter wave or the low bands? To get into that, we'd 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 5 gs deployments, and that's why there is a significant growth. Great. Thank you. And then as you stated both in this call and last call that 5 gs will probably be more about enterprise and private networks than just raw consumer demand. So 4 gs, we saw big capacity expansions in consumer demand. And in 5 gs, I know you mentioned initially mobile broadband, but that it would be followed by, like I said, enterprise and private client. And Nokia has 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? And as a result, shouldn't we see some sort of variation on the profile of your revenues, say higher gross margin, but lower growth given verticals tending go slower, but you feel better pricing power? We're still so early in this development. But what is clear is that connectivity in the enterprise sector is increasingly important. And wireless connectivity that is reliable and secure is very hard to get unless on your own life and spectrum. So we see an increasing interest from enterprises, and we see that with our partnerships. And we just recently, for example, had a big win in Germany with an automotive company. So we are seeing this to change the fundamentals of the business. So the way we think about it is that we have a consumer business, just as you said. That's the bread and butter. But on top of that, we are starting to see an 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 thank you. And 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 and it hasn't gotten large at this point. But 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 a larger share hardware software with a better gross margin than service revenues, right, less of the rollout revenue, call it that. So where that operator, we are ready for the next question. Thank you. And that's over to the line of Adam Doval at Goldman Sachs. Please go ahead. Your line is now open. Hi, Adam. 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. So 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. 2nd of all, there were some news reports in the last month or 2 about Ericsson's market share, at 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. So if we break it down a bit, and you're right to say that the majority of the improvement here comes from the improved profit as such. But if we look at working capital, then we given the high business activity we have, we see some buildup in the quarter of inventory. And that's followed, to some extent, because it's sourced, obviously, from 3rd parties to a large extent. Because we source, obviously, from 3rd parties to a large extent. But what was 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 points there. And that generated, and as Murray said before, this positive cash flow of 2,200,000,000 which we haven't really seen in the Q2 for a long time. And also looking at year to date, we are $5,700,000,000 better than 2018. Okay. And market share? Market share, it is so far in China, we're very early in the 5 gs cycle. So it's a little bit too early to have a firm view. What we are clearly aiming for is that we would be have a stronger market share in 5 gs than in 4 gs. Gs. And we have invested for that and conducted field trials for that. But 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. But that's where we are right now. That's great. And maybe just Olivier, I think we can also say we are we have it's always a bit hard to know exactly what the macro data will show once they come. 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. Okay. We're now over to the line of Sandeep Deshpande at JPMorgan. Please go ahead. Your line is open. Yes. Hi. Thanks for letting me on. I have a question on 5 gs. Gs. How do you think, Mohit, that 5 gs is going to be different from the 4 gs rollout? Because initially, as you said, that it 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? And 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 the United States, Korea, Japan, etcetera? Or is this going to be a point technology? We actually ultimately think all frequency bands will be 5 gs enabled, which means all operators want to leverage the full spectrum portfolio and the full, call it, and the full coverage. And that's what's ultimately going to provide the long term value of 5 gs. So 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 a undisturbed and with a very high degree of reliability, but they're 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 driven where you benefit the 5 gs 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 similar type of build out over time as you see with 4 gs. But that's going to clearly take a time and it's going to be focused initially on where you have industrial applications. Did I answer your questions? Yes. But just a follow-up to that would be, so does that mean based on what you're saying that you see given that this is 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? Without getting 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 the base business 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 consumer, but ultimately for enterprise. And that's why we're rather optimistic of the long term outlook of the need for 5 gs gs technology. Thank you. And we're open for next question, please. Yes. The next question is over the line of Simon Hald at Raymond James. Please go ahead. Your line is now Asia region. Specifically, I want to understand what your assumptions are in terms of the timing for the China 5 gs. And the question is rooted in the potential that maybe be given the trade tensions between the U. S. And China 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 Thank you. Just start by China, I can region? Thank you. Just start by China, I can comment on that. We have said that we believe large scale deployments will be 20 20, but we will see some emerging deployments in the second half. That is still the best judgment we have. And trade tensions, geopolitical uncertainty, etcetera, will bring is very hard to speculate on. So if that impacts, we really don't know right now. But we plan for seeing bigger deployments in 2020. We're also seeing, of course, the we're participant in the 5 gs rollouts in Korea, and that's been going on for some time. So we have networks there 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 have just been 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 5 gs to capture the opportunities. 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. And how big have Korea and Japan been in general within the business overall? Are they combined kind of 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. So except that we have said that I believe Korea is a top 5 market right now. So you can see that. Call it, it's about 4% or so. Top line. Top line. Great. Thank you for taking the question. And the size then of Japan once it's in fuller swing. Yes. 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. So on Media Solutions, I see that you still have an operating loss of a couple of DKK 100,000,000 in the quarter. I thought that this was already deconsolidated and 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 gross margin. So the way I think about it going forward is like 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. 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? I can oh, should I take the MediaKind? Yes, you can take the MediaKind. But I shall you're right, it is coming in now. The MediaKind investment has 49% of earnings. It comes on the line, share of earnings in the joint ventures and associated companies. And you're right, there was a loss in the company, and we get 49% of that. We're not guiding specifically on how that will develop. Obviously, the intention of the 2 shareholders is to improve on this business and turn it around as well. Sorry, just to clarify, Karl. So the EUR 200,000,000 loss is 49% of the total loss is equal to EUR 200,000,000 loss that you report? Majority is that, yes. Okay. Fortunately, costs are higher than revenues in that business. So far. So far. But the 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. And that so you can see somewhat more than the 20 basis points, but not dramatically more. Okay. 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, 1st of all, if we look at the portion of sales in North America, especially in Networks, it remains very high. And 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? And could that be as the North American market starts to normalize from the big 5 gs rollouts that we see now, would 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 in 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. And 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? If we start with the first one, what we see is or what we're trying to say is that you see a larger service portion in the second half. And of course, that is helping or 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 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 a very high rate, and we don't see the same growth rate continuing. But we do we also see an increasing 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 warning in any way on that. If you look longer term, I mean, do think that the interesting part here is so far the business has been exclusively focused on the consumer a 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. Richard, are you happy? Yes. Thank you. And 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. Yes. Hi. Just sorry to belabor on the margin, but 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? Or 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. But from a strategic project standpoint, that kind of 20 basis point headwind that you just talked about, will that continue into next year? Or is that something that will go away? I mean, they will our view of the reason why we take those is to position ourselves for 5 gs. So we are, of course, taking those contracts in the knowledge of that's not 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 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. Then we are actually open for the last question of this session. So please, operator? Yes, of course. The last question 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? And second, can you elaborate on kind of the advantages versus Nokia technology, etcetera? 2nd 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 5 gs to kind of 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 that's kind of 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. 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 release spectrum. That would help for a national rollout perspective. But from our demand perspective, we think we're 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. In the longer term, we need the mid band in order to capitalize on new opportunities for 5 gs and new use cases for 5 gs. My first question and ask it more in general, not versus a specific competitor. What drives your share Do you have do you think you have a sustainable technical advantage that can take you to 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 now? And do you expect it to kind of even out in the next few quarters? We took the steps to invest in making our or technology leadership to make our portfolio competitive. And that's in order to invest to stay ahead. So 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. So it's increasingly difficult to catch up, for example, on dynamic spectrum sharing that we can do on our baseband from 2015 and onwards. So of course, for our customers like Swisscom in Switzerland, they can actually achieve 90% population coverage by year end by 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 makes 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. And 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 improve profit or lower the loss, turning that into a profitable business next year. Managed Services has a bit of a lower margin in Q2 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 Iconnective 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. Thank you.