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Earnings Call Transcript 2019-Q2

[Operator]

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.ericsson.com/press or www.ericsson.com/investors [Operator Instructions] And as a reminder, replay will be available 1 hour after today's call. Peter Nyquist will now open the call. Please begin, sir.

[Peter Nyquist, VP & Head of Investor Relations]

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 Börje Ekholm; and our CFO Carl Mellander. 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 hence spend more of the time on the Q&A. But 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 assumption, which are subject to risks and uncertainties. The actual results may differ materially due to factor 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. So please, Börje.

[E. Börje Ekholm, President, CEO & Director]

Thank you, Mr. Nyquist, and welcome to this second quarter presentation. And 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 and 2022. 5G 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 5G 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 priorities 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 2/3 of our commercially launched networks. And we're moving now from a face of being first, being fast on paper into becoming leading in in-field performance. And here, we see we are making good progress.We see today also in all ongoing engagements in customers, we see 5G featuring very prominently, and 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. But the real potential over time will be enterprise-driven use cases, where we build the leverage, the capabilities 5G can give in terms of high-speed, low latency, low battery consumptions, many connections per surface units, et cetera. 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 5G.Cash flow was SEK 2.2 billion in the second quarter, and that's after absorbing large conversion of 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 leader, so we continue to invest in our 5G portfolio, both in the -- in radio but also in the cloud-native core portfolio in the digital services. But in addition, we are increasing our investments in R&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 -- or 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 revenue during Q1. Networks had good growth of 11%, driven by 5G traction and strategic contracts. 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-accretive 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 second quarter, but we 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. But we see good traction in the turnaround and cost 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, softer sales in the second quarter than last year. We are, though, seeing a number of positive signs, for example, our cloud-native offerings are gaining momentum. We see that our new BSS strategies also gaining traction with customers where 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 a flat sales if you adjust for the planned content exit. Gross margin declined due to timing between quarters or cost basically. And here, we are taking some short-term cost as we increase R&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 iconectiv business. And 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, 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 first quarter, which helped gross margin and gave it 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 little bit lower software portion in Digital Services and some timing of cost 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. So if we look at the Q1 gross margin, it was 43.2%. What we have here is a unseasonably large IPR revenues in Q1, which, of course, then can -- relates a bit to some old -- or catch up payments on old contracts. And that -- if you remove that, you get to adjusted Q1 margin, 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 so it would be about 42.4% and the IPR revenue 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 on 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 contracts 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&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%.

[Peter Nyquist, VP & Head of Investor Relations]

Okay, good. We stop there for a while, and we can back come to closing remarks from Börje later on. But now I would like to hand over to the operator again and for question and answers. So please, operator.

[Operator]

[Operator Instructions] And so for the first one, we to go to the line of Ed Snyder at Charter Equity Research.

[Edward Francis Snyder, Managing Director and Principal Analyst]

The question on your strength in North America. I know we've talked about this at length before and you've mentioned 5G in different variants of it. But if we could maybe get a high-level view, is the vast majority of that due to 5G build-out? Or are you seeing capacity expansions in 4G? And to the extent it is 5G, is it mostly millimeter wave or the low bands?

[E. Börje Ekholm, President, CEO & Director]

To get into that, would 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 a -- the most important part. But of course, we see as well the 5G deployment, and that's why it -- there is a significant growth.

[Edward Francis Snyder, Managing Director and Principal Analyst]

Great. And then you stated, on this call and last call, that 5G will probably be more about enterprise and private networks and to throw off consumer demand. So 4G we saw big capacity expansions since consumer demand, and at 5G, I know you mentioned initially mobile broadband, but that it will be followed by, let's say, enterprise and private client. And Nokia has essentially said about the same thing. Even that a fundamental change in the addressable market from like a mass-market horizontal product and 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 vertical spending goes slower but you've got better pricing power?

[E. Börje Ekholm, President, CEO & Director]

We are still so early in this development. But what is clear is that connectivity in the enterprise sector is increasingly important. And while this connectivity that is reliable and secure is very hard to get unless you're on license 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 changed 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 a enterprise segment emerging. But it's still too early to talk about it as a big market. It's just in its infancy.

[Edward Francis Snyder, Managing Director and Principal Analyst]

Would you anticipate any -- and I guess the last question related to that is, given the emergence of the enterprise as more of a private client in 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?

[E. Börje Ekholm, President, CEO & Director]

I think we -- it's a bit speculative, yes. But what you are likely to see is larger share hardware, software with a better gross margin than service revenues. Lesser the rollout revenues, call it that. So where that will ultimately going to end up it's too early to tell.

[Operator]

And that's over the line of Alex Duval from Goldman Sachs.

[Alexander Duval, Equity Analyst]

Firstly, just want to ask on your free cash flow, which seemed especially strong in the quarter particularly when you factor in provisions even 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. Second of all, there was some news report in the last month or 2 about Ericsson's market share, one of it Chinese telcos going up significantly. I will -- as 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 see it about your competitive positioning and opportunities?

[Carl Mellander]

Should I take cash flow first? Alex, so if we break it down a bit, and you're right to say that the majority of the improvement there comes from the improved profit as such. But if we look at working capital, and we -- given the high business activity we have, we see some buildup in the quarter of inventory. And that's followed to some extent by payables as well because it goes together often with inventory buildup as well with resource obviously from third parties to a large extent. But what 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 Börje said before, this positive cash flow at SEK 2.2 billion, which we haven't really seen in the second quarter for a long time. And also looking at year-to-date, we are at SEK 5.7 billion better than 2018.

[Alexander Duval, Equity Analyst]

Then market share?

[E. Börje Ekholm, President, CEO & Director]

Market share, it is -- 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 be -- have a stronger market share in 5G than in 4G. 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.

[Alexander Duval, Equity Analyst]

That's great. And maybe just...

[E. Börje Ekholm, President, CEO & Director]

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.

[Operator]

Okay. We're now over to the line of Sandeep Deshpande at JPMorgan.

[Sandeep Sudhir Deshpande, Research Analyst]

I have a question on 5G. How do you think, Börje, that 5G is going to be different from the 4G rollout? Because initially, as you've 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? And particularly, in some of these early markets such as the United States, Korea, Japan, et cetera? Or is this going to be a point technology?

[E. Börje Ekholm, President, CEO & Director]

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, call it, and the full coverage. And that's what's ultimately going to provide the long-term value of 5G. 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 tree ], there where you benefit the 5G 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 -- in a way similar type of build-out over time as you see with 4G. But that's going to clearly take a time, and it's going to be focused initially on where we have big capacity needs and big industrial applications. Did that answer our questions?

[Sandeep Sudhir Deshpande, Research Analyst]

Yes. Börje, just a follow up to that would be, does that mean, basically, what you are saying, that you see -- given that this is -- you're seeing such a strong upcycle in terms of your revenue growth in Networks this year, that this could be a multiyear process?

[E. Börje Ekholm, President, CEO & Director]

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 are rather optimistic of the long-term outlook of the need for 5G technology.

[Operator]

Yes. The next question is from the line of Simon Leopold at Raymond James.

[Simon Matthew Leopold, Research Analyst]

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? And the question is rooted in the potential that maybe given the trade tensions between 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 materiality of your business outside of China specifically, South Korea, Japan, which I'm assuming are included in that region.

[E. Börje Ekholm, President, CEO & Director]

We'll start by China, I can comment on that. We have said that we believe large-scale deployments will be 2020. But we will see some emerging deployments in the second half, that is still the best judgment we have. And I think it is fair to say with the trade tensions, geopolitical uncertainty, et cetera will bring it's very hard to speculate on. So if that impact -- 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 participating in 5G rollouts in North 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 5G to capture the opportunities. So overall, we're quite excited about the prospects in Northeast Asia as we see that, that is the leading technology region as well as investment region.

[Simon Matthew Leopold, Research Analyst]

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?

[E. Börje Ekholm, President, CEO & Director]

They are sizable markets. We don't provide you with the breakdown of the countries. So except that we have said, I believe, Korea is a top 5 market right now. So you can see that. Call it, it's about 4% or so of topline. So it -- but we can understand the size then of Japan once it's in fuller swing.

[Operator]

We are now over to the line of Achal Sultania at Crédit Suisse.

[Achal Sultania, Director]

So on Media Solutions, I see that you still have an operating loss of couple of hundred million kronor 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 second half? And then secondly, on the gross margin, again, so Börje, obviously, thanks for explaining the moving parts 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 the 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?

[Carl Mellander]

Achal, you're right. It's coming in now -- the Media kind investment, that's the 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 then in the company, and we get 49% of that. We're not guiding specifically on how that will develop. So obviously, the intention of the 2 shareholders is to improve on this business and turn it around as well.

[Achal Sultania, Director]

So just to clarify, Carl, so the SEK 200 million loss is 49% of the total losses equal to SEK 200 million loss that you report?

[Carl Mellander]

Majority of that, yes.

[E. Börje Ekholm, President, CEO & Director]

Unfortunately, costs are higher than revenues in that business, so far. But the intention is, certainly 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.

[Operator]

Is over to the line of Richard Kramer at Arete Research.

[Richard Alan Kramer, Senior Analyst]

My 2 questions are, first of all, if we look at the portion of sales in North America, especially in Networks, it remained 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 America market starts to normalize from the big 5G 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 the -- this -- these quarters moves in gross margins in Networks, can we remove the IPR income from both Networks' sales and margins over the last 1.5 years? Your core Networks business margin seems to be around 10% and/or 11% roughly. And given that nearly all of those network sales come from telcos, is that the sort of kicker or reasonable margin you can expect in negotiations with what a very large customers and obviously, now very well accustomed to a 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?

[E. Börje Ekholm, President, CEO & Director]

If we start with the first one. What we see is so -- or what you'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 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 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 a 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 the gross margins second half is -- or in any way dramatically deviating from the guidance we have given. So we're not trying to give a profit warning in any way on that. If you look longer term, I mean, I do think that the interesting part here is so far the business is being exclusively focused on the consumer business. We see that, that is changing into becoming 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.

[Operator]

Okay, the next question is over to the line of Stefan Slowinski of Exane BNP Paribas.

[Stefan Julien Henri Slowinski, Research Analyst]

Just start to belabor on the margin but -- on the gross margin, you kind of quantify here with the new slides, 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 the 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?

[E. Börje Ekholm, President, CEO & Director]

I mean there will -- our review -- the reason that we take those is to position ourselves for 5G. 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.

[Operator]

The last question for today's call is over to the line of Tal Liani at Bank of America.

[Tal Liani]

This is Tal from Bank of America. I have 2 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 et cetera. Second question is about North America. What happens if there are delays in allocating Spectrum on between a half gig in North America. Do you expect 5G 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?

[E. Börje Ekholm, President, CEO & Director]

The -- 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. Longer term, we need the mid-band in order to capitalize on new opportunities for 5G and new use cases for 5G.

[Tal Liani]

So if I can go back mainly -- maybe to my first question and ask it more in general, not versus a specific competitor. What drives your share gains? 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? And do you expect it to kind of even out in the next few quarters?

[E. Börje Ekholm, President, CEO & Director]

We took the steps to invest in making our 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 to a 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 2 factors coming through.

[Peter Nyquist, VP & Head of Investor Relations]

And before we close this, Börje do you want to have the last remark?

[E. Börje Ekholm, President, CEO & Director]

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 the IPR swings versus Q1. We continue to execute on the plan in Digital Services to gradually and sequentially improve -- or 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 course. But we see that our investments in automation and machine learning is starting to pay off in operations engine, that's longer term going to drive a very different margin profile. Emerging Business saw a good growth, driven by our profitable iconectiv 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.

[Carl Mellander]

Thank you. Goodbye.