ERIC - Ericsson Has 43% Upside Potential Over The Next 3 Years

2023-06-23 12:03:03 ET

Summary

• Ericsson's stock has potential for a 43% upside due to the expected recovery of its business and the possibility of lower interest rates.
• The company's growth driver is the rollout of 5G networks, which is expected to regain momentum later this year or early next year.
• Ericsson is currently trading at only 7.7 times its expected earnings in 2025.

I have always avoided Ericsson ( ERIC ) due to its highly volatile performance record and its unreliable business performance. The stock has plunged 34% over the last 12 months, to a fresh 10-year low. The daunting underperformance of the stock vs. the S&P 500 (-34% vs. +17%) has resulted primarily from some business headwinds facing the company. However, these business headwinds are likely to abate in the upcoming years and hence the stock has become exceptionally cheap from a long-term perspective. In this article, I will analyze why Ericsson has 43% upside potential off its depressed stock price.

Business overview

Together with its subsidiaries, Ericsson provides communication infrastructure, services, and software solutions to the telecom and other sectors. It is headquartered in Sweden and has approximately 100,000 employees.

Ericsson has exhibited a highly volatile and uninspiring performance record over the last nine years, partly due to a steady decline in global demand for radio access equipment, which used to be a significant growth driver for the company in the past. Since 2013, the revenues of Ericsson have decreased by 3.8% per year on average and earnings per share have declined from $0.57 in 2013 to $0.50 in the last 12 months.

The long-term decline in the sales and earnings of the company raise a red flag and signal that the stock is not a buy-and-hold-forever stock. Indeed, Ericsson has underperformed the broad market by a wide margin over the last decade. During this period, the stock has shed 55% whereas the S&P 500 has rallied 171%.

Moreover, Ericsson is experiencing weak business trends right now. In the first quarter, it posted flat organic sales and its gross margin shrank from 42.3% to 39.8% due to high cost inflation and decreased revenues in the network division amid slow deployment in early 5G markets. The bottom line was also affected by restructuring charges and increased R&D expenses and thus earnings per share plunged 49% over the prior year’s quarter.

Management expects the weak business trends to persist in the second quarter due to a sharp deceleration in the rollout of 5G in many countries. Analysts seem to agree on this outlook, as they expect the company to incur a 27% decrease in its earnings per share this year, from $0.59 to $0.43.

However, it is important to realize that the current business headwinds are likely to abate in the near future. The deployment of 5G networks is likely to regain steam in the second half of this year, as per the latest conference call of the company. This deployment is likely to prove a major growth driver over the next two years. For instance, there is immense growth potential in the Indian 5G network.

It is also worth noting that there were some bright spots in the latest earnings report of Ericsson. The company posted organic growth of 5% in Cloud Software and Services and 19% in Enterprise. The Enterprise segment, which now represents almost 10% of sales, is highly promising, as it is shaping the future industry landscape through network Application Programming Interface [API] platforms. Management recently mentioned successful tests and demonstrations of network APIs with partners and expressed optimism about the potential of this market. In addition, management expects the Cloud Software and Services segment to reach a breakeven point this year.

Analysts seem to agree that Ericsson will recover from its current business headwinds in the next few years. They expect the company to grow its earnings per share from $0.43 this year to $0.60 in 2024 and $0.66 in 2025. If the company meets the analysts’ estimates in 2025, it will achieve one of its best performances in a whole decade, primarily thanks to the rollout of 5G and the strong demand for API platforms.

Valuation – Expected return

Ericsson is currently trading at a forward price-to-earnings ratio of 11.9, which is much lower than the 10-year average price-to-earnings ratio of 17.1 of the stock. The cheap valuation has resulted primarily from the negative business momentum prevailing right now and the multi-year high interest rates, which have greatly reduced the present value of future earnings.

However, the business of Ericsson is likely to begin to recover later this year. It is also important to note that the stock is trading at only 7.7 times its expected earnings in 2025. Moreover, as inflation has subsided every single month since it peaked 12 months ago, the Fed is likely to begin reducing interest rates next year. Lower interest rates are likely to provide a strong tailwind to the valuation of Ericsson, as they will increase the present value of future earnings.

Overall, as the business of Ericsson is likely to recover and interest rates will probably revert towards normal levels over the next three years, the stock of Ericsson seems to have significant upside potential. If the earnings multiple of Ericsson recovers from a 10-year low of 7.7 to 11.0, which is still much lower than the 10-year average of the stock, the latter will rally 43% (=11.0/7.7 – 1) off its current price.

Risk

The primary risk of Ericsson is its highly volatile and unreliable business performance in the long run. However, the company has a strong growth driver in place right now, namely the rollout of 5G in several countries. While the deployment of 5G has decelerated in the first half of this year, it will almost certainly regain steam later this year or early next year, in line with the expectations of management and analysts.

Moreover, the bar of expectations, as evidenced by the 10-year low valuation level, has been set too low by the market. As a result, the stock is unlikely to disappoint the market from its current depressed price. Overall, given the 10-year low stock price and the 10-year low valuation level of Ericsson, the stock is likely to recover strongly whenever the first signs of business improvement show up on the horizon.

Final thoughts

As mentioned above, Ericsson is likely to highly reward patient investors at some point in the future. On the other hand, investors should be aware that this is not a buy-and-hold stock. Its dramatic underperformance over the last decade (-55% vs. +171% of the S&P 500) is a stern reminder of the excessive risk of this stock. As soon as Ericsson approaches its target price of $7.26 (=11.0*0.66), investors should take their profits and look elsewhere for attractive returns. It is impossible to call the top of the stock while its risk does not justify holding this stock for the long run.

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