Description

Summary:

Ericsson (ERIC) is a major beneficiary of the massive spending to upgrade to 5G over the next few years and is a direct beneficiary of the trade war with China as mobile operators cancel contracts with Huawei and sign deals with ERIC and Nokia (NOK).

“To date, we have provided solutions for almost two-thirds of all commercially launched 5G networks. 5G momentum is increasing.” – Ericsson CEO in latest quarterly earnings press release

Background on the Business:

More seasoned folks may remember ERIC as one of the darlings of the 90’s tech boom where, along with Nokia, it pioneered the business of mobile phones. Back then, roughly 20% of all cell phones sold were made by Ericsson and the stock went 10x from 1996 to 2000. Ericsson combined its phone business with Sony in 2001 to create Sony Ericsson, but the JV missed the move to smart phones and that business cratered. ERIC eventually sold its portion to Sony in 2011. The stock is still down over 90% from its 2000 high.

Ericsson has also long been a dominant player in the mobile network infrastructure market, but during the 2000s, as management was trying to make up for the lost revenue share on its declining phone business, it waded into all kinds of unrelated businesses that diluted its focus and resources.

Since 2012, ERIC’s network infrastructure business has been losing market share to Chinese competitors Huawei and ZTE. It had gone from being the market share leader in 2012 to third place in 2016, with Huawei leading at 20.4%, Nokia (who acquired Alcatel-Lucent) in second with 14%, ERIC in third with 12.5% and ZTE coming in fourth with 9.2%.

By the end of 2016 the Board had had enough and decided it needed to get ahead of the 5G upgrade and redoubled its efforts on gaining market share. They fired the CEO and brought in Borje Eklhom to lead the turnaround efforts. Since that point in time they’ve slimmed down considerably, cutting over 20K jobs (nearly 20% of workforce), sold off non-core businesses and he has shaken up the management team multiple times. As a testimony to their focusing efforts, the Networks segment has gone from 49.5% of total revenue in 2012 to now 69% in the latest quarter. The overall business has gone from losing money in 2017 to an estimated 9.2% operating margin for 2019 with goals of reaching over 10% op margins for 2020.

5G:

Let’s talk 5G, as this is the cornerstone of the investment thesis.

1G started in the 80s which allowed us to first make calls using those massive brick phones. 2G launched in the 90s and enabled us to send and receive text messages. 3G came “online” in the 2000s and let us connect to the internet through our phones for the first time. While it was slow, this is what really enabled the smartphone revolution to take off. 4G arrived in 2010 and with it the ability to much more easily stream videos, download music, play video games, use real-time geo-tracking like Google Maps, etc.

Many of the successful businesses out there that have seen meteoric rises over the past decade, such as Netflix, Spotify, Uber, Lyft, etc. would likely be unable to operate their current business models without 4G technology.

5G is estimated to be 1,000x faster than 4G, and with it will bring incredibly lucrative new business opportunities that were not possible with 4G. The one most people think about is autonomous driving and IoT as you may be able to now have cars that can gather and respond to network data as fast as humans can react (i.e. when the machine sees x combination of inputs it responds in y way) to their environment. There will be hundreds of billions if not trillions of dollars of new market value and economic activity created through businesses that will be enabled through the use of 5G technology. GSM Association is estimating 5G will add $2.2T to global GDP over the next 15 years while IHS Markit believes 5G will enable $12.3 trillion of economic output by 2035.

This means it’s very important geo-politically to be first, because the companies that get to fly-wheel network effects first using the new technology will likely dominate globally. Not to mention the military advances that will be available through 5G.

In April, Trump noted: “We cannot allow any other country to out-compete the United States in this powerful industry of the future,” Trump said. “We are leading by so much in so many different industries of that type, and we just can’t let that happen. The race to 5G is a race America must win.”

5G technology is very different from 4G in that it is much faster but can only travel over shorter distances. 4G could potentially reach 50 miles while 5G can reach about half a mile. This means the entire mobile networks have to be upgraded with significantly more mini cell towers (search on Google Images for these… they can even go on light posts or telephone poles). Greensill (a leading provider of working capital finance) estimates that over $500 billion will be spent by telecom companies globally by the end of 2020 upgrading their networks with over $100 billion coming from the big 3 American carriers.

I quote all those stats just to make the point this is a massive tailwind for network hardware providers. And until recently, the best part of the tailwind was going to ZTE and Huawei.

The Huawei / ZTE Catalyst:

In May 2018, the Trump Administration blacklisted ZTE and banned sales of parts to the company due to it violating sanctions on North Korea and Iran. In May 2019, Trump also banned the sales of networking equipment and phones from Huawei to US companies due to numerous intelligence reports regarding the “backdoors” present in the equipment that could allow the Chinese government to spy on other countries and their citizens.

While some of the restrictions have been eased, much of the damage has been done. Regardless of what’s technically allowed, major telecom companies can’t take the risk. Prior to the ban, Huawei had secured almost $100 billion worth of 5G contracts and now almost all of them have been cancelled. AT&T and Vodafone have both cancelled them and other governments are now banning the use of Huawei equipment as well.

This means major telecom companies have to turn to Ericsson and Nokia to upgrade their networks to 5G. ERIC has publicly announced 5G contract wins with 24 telecom companies (can see most updated announcements here: https://www.ericsson.com/en/5g/5g-networks/5g-contracts) including all the major US carriers. Verizon has chosen ERIC as their sole provider of 5G equipment (VZ CEO used to be CEO of ERIC… so sounds like there are still some good relationships there). It’s also won contracts with Softbank, Vodafone, and a number of other major telecoms across Europe, Australia and the Middle East. We expect these contract announcements to continue and the execution / implementation of these contracts to ramp up over the next two years.

It’s worth addressing why not buy Nokia instead since the stock is still stuck in the mud and this community has an affinity for all things discarded. The short answer is we believe they will be a major winner as well (many of these companies are announcing contracts with both companies. For example, TMUS announced $3.5B contract to each Ericsson and Nokia), and they pay a healthy dividend. However, the companies have similar market caps and yet Nokia struggles to produce FCF compared to ERIC and has lower margins. So we prefer ERIC, however both have a large tailwind.

Valuation:

Short-term management comp has been refocused on economic profit (operating income less cost of capital) while long-term management comp structure is based on shareholder returns. Earnings have inflected positively in 2019 and in the last quarter sales have finally inflected positively as well.

The Street has ERIC sales growing to $27B and net margins expanding to 9% by 2022 due to the 5G buildout, large gains in cost efficiencies (due to layoffs and restructuring) and a focus on op margins by management.

We believe the Street is being too conservative because of ERIC’s spotty history. Particularly in light of the pressure on telcos to reduce reliance on Chinese equipment makers, Wall Street projections are likely on the lighter side. Execution under the new management team has been impressive and is meeting the goals they have laid out for investors. The increased order flow is already causing the company to see some ARPU expansion and likely will continue to provide a bit of pricing power due pressure to accelerate deployment of these networks and the low-cost Chinese competitors being out of the way.

Therefore, we estimate sales should be able to reach $30B by 2022 and at 12% op margins (mgmt. goal to be above 12% by then) and a 15x EV/EBIT multiple (currently trading at 18x LTM) including the cash build, we calculate the stock is worth over $17/share, which would provide over 100% upside over the next 3 years.

From a behavioral perspective, we tend to find that businesses both growing top line and expanding margins tend to also see substantial multiple expansion (whether that’s the correct way to value it or not over the long term) and therefore we would not be surprised if this is a conservative valuation as the company executes.

The Opportunity:

The stock is off over 20% since its April high with the biggest decline coming in early July after it reported Q2 earnings and gross margins came in lighter than expected. As the CEO explained on the call, gross margins were impacted compared to Q1 by patent settlements, receiving settlements in Q1 and paying settlements in Q2 so when you back this out the change is only a decline of 0.2%. He further explained that as 5G ramps, the company has to take some upfront margin hit to win/implement these strategic contracts, but over the next 3 to 4 quarters after it starts they gain the gross margin back and begin to get material operating leverage. So margins were negatively impacted by the upfront spend and offset by operating leverage from previous contracts. This should have the impact over the next few years of holding margins back for a period of time and then seeing them begin to move rapidly upward.

Additionally, on the call they touched on numerous times that what allows them to win these big contracts is having the best technology and therefore they are going to continue to invest in R&D to maintain an edge and try to get a couple of the struggling segments to become much more profitable.

Wall Street doesn’t like short-term margin pressure for long-term gain because it doesn’t trust the long-term (except maybe for NFLX, AMZN and SaaS companies). Therefore, we are getting an opportunity to buy the stock on a 20% decline here due to short-term noise.

Some selling pressure may also have come from Trump beginning to soften up a bit on Huawei, but it’s hard to say because as of today tensions are flaring up again.

Why It’s a Bit of a Hedge Against the Trade War:

While shorter term the stock is fairly highly correlated with the overall market, longer term its value is tied to its success in 5G. Therefore, if the trade war with China gets worse, it’s unlikely Trump is going to simply give a green light on Huawei (which had been stealing share and undercutting ERIC on price in 5G). If the trade war gets dramatically better and he allows some reprieve, the rest of your portfolio likely responds positively. So it’s likely that the worst case scenario competitively for ERIC (where all restrictions on Huawei are removed and its position of prominence restored) comes from an environment where other major market overhangs are removed and stocks are repricing higher.

Catalyst

·        Commercial launches of 5G globally

·        The 5G evolution from consumer use cases to enterprise use cases (much more profitable for ERIC long-term)