ERIXF - Ericsson Looks Like A Value Trap Unless It Can Transform Its Enterprise Operations

2023-09-27 13:35:18 ET

Summary

• Lackluster demand for 5G equipment has pressured the business throughout 2023 and the next 12-24 months aren't looking substantially better either.
• The company's other businesses, including CSS and Enterprise, are unlikely to offset the decline in the Networks business, though losses are shrinking in both.
• Ericsson may need to consider M&A to reshape the business and improve its leverage to growth opportunities in enterprise end-markets.
• Ericsson shares may look like a value, but it's often tough to make money in value-driven ideas with such little apparent top-line growth potential.

Expectations for radio access network (or RAN) providers like Nokia Oyj (NOK) and Telefonaktiebolaget LM Ericsson (publ) (ERIC) were hardly bullish to start the year, but as bears predicted (and I previewed in my last piece on Ericsson ), the results have been even worse. For all intents and purposes, major deployments are over in North America and European carriers have been “sluggish” in expanding midband coverage. While India offers some opportunity (the only major growth market now, really), it’s at lower margins.

Worse still for Ericsson, the company has struggled to gain traction with its Cloud Software and Services (or CSS) business and has made some questionable strategic bets with its Enterprise business (including the 2022 deal for Vonage). With weaker base results, the shares have continued to underperform, falling another 17% since my last update, and there really isn’t much on the horizon that looks like a positive driver beyond cost-cutting.

Ericsson may look undervalued by conventional approaches, and indeed I can get to fair values suggesting 15% plus upside even with what I think are conservative estimates. Still, the poor growth outlook creates a very real risk that this is a value trap, and while Ericsson has the resources to use M&A to improve the long-term growth outlook, it remains to be seen if management has the will to execute (and if investors would support) a meaningful M&A transaction.

It Was Never Going To Be Good…

Expectations for RAN spending in 2023 weren’t strong to begin with, and if anything have proven weaker than initial expectations. In North America, AT&T (T) and Verizon (VZ) are basically done with their 5G deployments (including C-band) and all that’s really left is some modest backfilling for private networks and rural areas. Europe, too, has done a lot of the heavy lifting, and although midband coverage is much lower, there doesn’t seem to be any urgency to accelerate deployments.

That doesn’t leave a lot on the table for Ericsson. India is offering some growth today, but it’s at lower margins, and even if Ericsson’s bullishness on fixed wireless access (or FWA) is validated (management has talked about 100M potential connections), I don’t think it really fixes the overall demand/revenue growth issue. Likewise, while displacing Huawei was supposed to be a driver, and still could be, there are risks that rivals like Ciena (CIEN) and Samsung benefit the most from that opportunity.

Networks revenue declined 8% as reported in the second quarter at Ericsson, and overall North American revenue was down 42%. Revenue should pick up some in the second half (helped by India), but the business is still likely to decline around 4% for 2023 and there likely won’t be much growth in 2024 or 2025. Deployment of 6G is still some time off, and while I do think there’s a real opportunity in enterprise 5G (to support IoT and digitalization), that too will need time and Ericsson’s product lineup may not be well-suited for a market that could choose to go with a more open architecture approach.

The Cavalry Isn’t Coming

Unfortunately, there really isn’t anything in Ericsson’s other businesses that can offset the lackluster demand in the Networks business. The CSS business is seeing smaller losses, which is a positive, but quarter to quarter performance has been erratic, and I expect three-year compound growth here in the low single-digits.

Enterprise is likewise no help. I think Ericsson made a poor decision acquiring Vonage and has misread how the enterprise space has been developing, leaving it on the outside of more exciting opportunities like networking and interconnect. To that end, I’m not expecting much net growth from this business either, and I still expect that it will be a money-losing business in FY’25.

That leaves cost-cutting as a source of better results, and to Ericsson’s credit, they are stepping up cost-cutting efforts. Roughly $1B in cost cuts are “on track” (more than half of which are coming from reduced COGS), but companies rarely cost-cut their way to prosperity and these efficiency initiatives don’t come close to counterbalancing the top-line growth issues.

Could M&A Be An Answer?

As I’ve said in this article and in prior articles, I do think enterprise/industrial IoT is a real opportunity and a market that will continue to develop in the coming years. More and more industries are embracing digitalization as a way to improve operating efficiency, safety, and profitability, ranging from digitalizing factory floors, using remote monitoring and predictive maintenance, and digitalizing mines and ports to optimize performance. Add in other opportunities like augmented reality and digital twinning, and I expect a lot of wireless traffic in industrial markets in the coming years.

Ericsson could be a player here with its RAN portfolio, but if open RAN (or O-RAN, basically a whitebox approach that deprioritizes hardware from specific vendors) proves the more popular option, it will cut into Ericsson’s opportunity. Moreover, the company just doesn’t have many other plays on that opportunity – Nokia, at least, as recently launched new MIMO radios (with its proprietary ReefShark chipset) for these markets, and companies like Ciena offer edge routing/switching, as well as interconnect products.

As much as I think Vonage was the wrong move, I think Ericsson may want to consider M&A as a way to reshape the business. The company has a clean balance sheet and could afford to do something sizable. I’m not suggesting that acquiring Ciena would necessarily be the right move (and/or that it would pass antitrust inspection), but Ericsson could likely make a deal that large work financially. If a deal that large can work, there are a lot of smaller deals that could work as well, so I don’t think Ericsson is without options to improve its leverage to growth opportunities in enterprise end-markets.

The Outlook

As is, I think Ericsson looks like a 1% to 2% long-term revenue growth story; 6G and enterprise 5G could offer some upside, but I do think Ericsson is much too dependent on carrier capex and has too little exposure to real growth opportunities in enterprise end-markets. On the margin side, I think the company can maintain EBITDA margins in the low double-digits and I still think mid-single-digit free cash flow margins are sustainable. With that, the company will continue to generate solid cash flows that should either be used to improve the company’s long-term growth/return profile or returned to shareholders.

Discounted cash flows give me a fair value of around $5.50 today, and I’d note that my revenue estimates from 2023-2026 are below the sell-side averages (about 3% to 7% depending on the year, or 5% summing them all together). My margin and free cash flow margin estimates are likewise somewhat lower than sell-side expectations. I’d also note that I could make a case for a fair value as high as $7.25 based upon the company’s margins and returns (ROIC, et al.), but the significantly below-average growth outlook is a consideration that should not be ignored.

I do also see a risk that sell-side expectations could have further to fall over the next few quarters. Sell-side bulls on Ericsson have talked about the company’s revenue growth troubles as being a product of “inventory reductions” at major carriers, and while that’s technically true, I think it overlooks the fact that those customers are reducing inventories because they’re meaningfully scaling back their deployment plans, so it’s not as if they’ll need to replenish those inventories.

The Bottom Line

I do believe that there’s a fair price for every going concern, and I see no risk at this point of Ericsson going out of business. What I do see, though, is a risk of “muddle along” performance that fails to excite much interest among investors. Likewise, while I think the right M&A deal could help, M&A always involves risk and overspending on the wrong deal would only make a bad situation worse.

I can understand how some investors may find the low valuation appealing, but I do offer the warning that “how much worse can it get?” is a question you never really want to ask – even if the business results can’t or won’t get much worse, the shares can continue to underperform. Barring some sort of transformation in the end-markets or the company’s business plan that points to better results, I can’t really argue for owning Ericsson shares now.

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