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Earnings Call Transcript 2019-Q4

[Operator]

Welcome to Ericsson's analyst and media conference call for their fourth quarter reports. To view visual aids for this call, please log on to www.ericsson.com/press or www.ericsson.com/investors. [Operator Instructions] As a reminder, replay will be available 1 hour after today's conference.Peter Nyquist will now open the call.

[Peter Nyquist, VP & Head of Investor Relations]

Thank you, operator. And hello, everyone, and welcome to today's call, the Q4 call. With me here today, I have our CEO, Börje Ekholm; and our CFO, Carl Mellander.So this short statement first. During the call today, we will be making forward-looking statements. These statements are based on current expectations, certain planning assumptions which are subject to risks and uncertainties. The actual result may differ material due to factors mentioned in today's press release and discussed in this conference. We encourage you all to read about these risks and uncertainty in our earnings report as well as in our annual report.With that said, I would like to hand over the call to our CEO, Börje Ekholm. So please, Börje.

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

Thanks, Peter. Welcome, and thank you for joining us for this report for the fourth quarter.And again, Q4 marks another quarter of execution on the focused strategy building on technology leadership, cost leadership, product-led solutions and global skill and scale, and we continue here to benefit from our strength and competitiveness. As we grow faster than the market, we've maintained strong gross margin. Our underlying business fundamentals remain strong, and we feel we have a very solid competitive position. Top line grew organically during 2019 with 4% and 1% during Q4.We are in the beginning of a technology shift, and our investment to lead in 5G is now starting to yield results. Today, we have 79 contracts and 24 live 5G networks. And we see that we now win new contracts based on our leading technology. The rollout of 5G continues in North America with good underlying growth. However, the uncertainty related to the announced merger has reduced sales in one account during the Q4. However, the decline in North America was compensated by good demand in Northeast Asia and the Middle East.We maintained a solid gross margin at 37.1% overall and 41.1% in Networks. The sequential reduction in gross margin in Networks was fully attributable to the Kathrein business that we acquired during the quarter. When we win new footprint, the overall margin in those contracts are positive and contributes to our long-term margin targets, but the initial margin is challenged. However, we also see during this last quarter that the initial low margins have been fully compensated by operating leverage, showing the strength on our -- of our underlying business. As I said, the acquisition of Kathrein closed during the quarter. This is a very important acquisition for us, as it will allow us to strengthen our antenna capabilities and improve our ability to supply integrated site solutions. We're now working on integrating Kathrein into Ericsson and thereby establishing and building a leading portfolio of antenna solutions, but the contribution during the fourth quarter was a negative on our operating margin.So if we look for the operating margin. Excluding restructuring and the fine to the U.S. authorities, it was 9.7% for the full 2019, actually putting us very close to the target for 2020 1 year early. In the fourth quarter was impacted by a couple of decisions we took. One is clearly the Kathrein acquisition that raised OpEx, but now we see it will pay off over time through strength and competitiveness in the antenna space. The other area where you see very discrete increases, and it's in OpEx, is for digital transformation. And that's critical investment for us to digitalize the internal ways of working and the way we interact with customers, fully in line with our focused strategy. We take these investments to take the next step in automating our processes, and we will see them gradually pay off during 2020 and into the future through better cost efficiencies. So that is clearly the investment program that, of course, has bumped up OpEx in the short term, but it should help lower longer-term OpEx. The other area that we're investing in is, of course, security as well as our compliance program. And that's impacting also the OpEx short term.The underlying business continued to be strong in Networks. And the gross margin, as I said, was a solid 41.1% during the quarter. The operating margin was sequentially reduced to 14.5% during Q4, and that's due to the Kathrein acquisition as well as Networks' share of the higher investment I just went through. For the full year, however, we are at 16% operating margin, which is in the range, and we're also very comfortable with the outlook.Digital Services. We continued to execute on the turnaround plan. And this past quarter, they reached a positive operating income despite actually provisions of about SEK 300 million for critical projects. And you know we have now resolved 3/4 of the 45 initially identified critical projects.The next item. Free cash flow before M&A was SEK 7.6 billion for the year. That's after the payment of the fine to SEC/DOJ. And if we were to look at cash flow before the fine, the free cash flow was the highest since 2010, showing the underlying strength of the business.And the Board proposes a dividend of SEK 1.50 per share, and that is to confirm the confidence in our strategy and ability to execute and reach the target sets for 2020, as well 2022.So it's -- short comments on the market for during the fourth quarter. We can see that overall the market in North America was very strong, except in the accounts affected by the uncertainty of the announced merger. And therefore, the sales overall shrank, FX adjusted. Europe was flat after growth in Networks was offset by contract exits. Latin America declined as large contracts were finished in 2018. Southeast Asia, Oceania and India grew based on strong demand for 4G. Northeast Asia grow following strong 4G and, I would say, 5G deliveries to prepare the network for 5G. And here, we suffered also from Digital Services that fell due to lower sales of legacy products. Middle East and Africa grew, driven by growth in the Middle East.To look for the full year, we saw that North America was very strong, of course, driven by the initial demand for 5G. We saw also Northeast Asia be very good. Europe fell due to contract exits for Europe and Latin America, and here, Latin America fell due to timing of large projects. Southeast Asia, Oceania and India fell slightly, and this is explained by decline of legacy products in India within Digital Services. Middle East, Africa was flat.With that, I'm going to give the word over to Carl.

[Carl Mellander]

Thank you, Börje. And good morning, good afternoon to everyone. Thanks for taking the time.Let's look at the full year performance, to start with then, where we reached SEK 227.2 billion in net sales and this corresponds to 4% organic growth. Gross margin at 37.5% is within the 2020 target range already. And the operating margin here at 5% was, of course, including the SEC/DOJ settlement, but if we exclude that, the operating margin was 9.7%, which is also close to the 2020 target, as Börje said. The full year operating income number, SEK 22.1 billion, again, adding -- having added back the SEC/DOJ settlement costs, and that's more than double the profit of 2018.Net income, positive number, improved to SEK 1.8 billion, driven by the higher operating income, of course, but also lower financial net. And earnings per share diluted here came out at SEK 0.67.Free cash flow, again, SEK 7.6 billion for the full year. And also here then, if adjusted for SEC/DOJ payment, we delivered SEK 17.8 billion free cash flow before M&A, which is 4x higher than that of 2018.Zooming in on the fourth quarter. Net sales SEK 66.4 billion, 1% up organically year-over-year. And here, the operating margin, 9.7%, was impacted by a couple of items. We made a partial release of the SEC and DOJ provision. I'll come back to that, SEK 0.7 billion. There was also a noncash element coming from the wind-down of that legal structure of a former joint venture we had, ST-Ericsson, which is included here in the costs with a negative SEK 0.3 billion. But yes, we can exclude for that, and then the operating income is SEK 6 billion and operating margin thereby 9%. Also you see net income improved here to SEK 4.5 billion from a negative minus SEK 6.5 billion last year.Finally then, free cash flow before M&A in the quarter was a negative minus SEK 1.9 billion, but of course, obviously in that amount, we have absorbed the SEK 10.1 billion payments to SEC and DOJ.But let me guide you through how the SEC and DOJ settlements have affected the accounting, and it's a bit of technicality but could be good to know. So the settlement was fully covered by the provision we took in the third quarter. We paid out the SEK 10.1 billion now during December. And that would, obviously, reduce the provision with the same amount, but then the interest component of the settlement came out lower than we had estimated when we made the provision. And this means that we could [ de-fall ] a further SEK 0.7 billion of the provision, and that's then again had an impact on the P&L now in the fourth quarter positively. So now we still remain with SEK 0.6 billion of provision for this purpose, and that will then cover future monitoring costs in this connection.Let's look quickly at the segment performance, starting with the largest segment, Networks. We see organic growth year-over-year of 2%. Sequentially, we grew Networks by 13%, but that's a bit lower than the historical seasonality which is typically 18%. As Börje described, this was really affected by or impacted by the uncertainty in the U.S., with one account coming in a bit lower, but the underlying business fundamentals in North America remained strong. I think that deserves repeating. So also encouraging to see then that while North America was somewhat weaker, several other markets stepped up and compensated here. And we saw particularly strong market growth in Japan and Saudi Arabia, for example, as they prepare to launch 5G.So gross margin in Networks stayed above 41%, solid but with a certain decline then quarter-over-quarter; I'll come back to that shortly. Operating margin 14.5% was down year-over-year and quarter-over-quarter. And in a minute, I'll go through a bit more of the key items behind that development. But for the full year, as you see in the graph, Networks delivered an operating margin of 16% excluding restructuring. And this is right in the middle of the 2020 target of between 15% and 17%.5G leadership momentum continues. We have now 78 or even 79, I believe, commercial 5G agreements, in checking this morning; and 24 live 5G networks. So that's going well as well. And here, we have earlier talked about strategic contracts, so I wanted to update you all on that as well, and the rationale for those contracts. And as you know now, in essence, these are selected few contracts that allow us to capture opportunities in the market to advance our position and they're coming, often typically, with lower initial margins but positive and value creating, of course, overall. And several quarters in a row, we have shown the impact of these contracts now. And what we do there is we net the impact of the contracts against what we call operational leverage, so Other offsetting profit improvement measures. So essentially, we look at the sequential gross margin development. And in Q4, as you can see here, the net effect was 0, of strategic contracts and operational leverage. And the whole effect sequentially is explained by Kathrein, as Börje mentioned before. Kathrein obviously is going to gradually improve over 2020. That's worth adding as well.So digging a bit further into Networks, I wanted to show this graph as well, so again, full year performance, very solid with a 16% operating margin. And also, Q4 gross margin can be deemed solid at 41.1%, but here I wanted to show a bit more on how operating margin has developed over the year. I think this is relevant to understand the bigger picture here. And as you see, the year-to-date operating margin has been rather stable at around 16%, with some fluctuations between quarters. And Q3 was, of course, a very strong quarter for Networks with 18.4% isolated operating margin. And you also can see in the graph how this was supported by a low OpEx ratio, while in Q4 OpEx came back to a bit higher levels but fairly in line with previous quarters also. And that, of course, is visible then in the operating margin.So we -- what we should consider here, and you see the bullets to the right: one, Kathrein about SEK 0.5 billion of impacts, that's 1 percentage point or so; and we have the investments that we have decided to make in digitalizing the enterprise, but also compliance and security; but then we also have customer financing revaluation and some impairment of accounts receivable, and that's an effect of SEK 0.3 billion in the quarter, and actually that was a positive number in the third quarter. We're obviously investing also in R&D. So if you look year-over-year, we've added also some SEK 900 million or so in R&D, yes. And lastly, the lower seasonality on top line also shines through here. Again, the full year performance in Networks, strong.Digital Services. And I think the main news item here is that the result was positive in the quarter. Börje mentioned it already. It's actually SEK 42 million, although we used billion SEK here with one decimal. It looks like it's 0.0, but it's actually SEK 42 million positive. So I think that's a great testament to the turnaround efforts in Digital Services.We see good momentum in the portfolio, customers migrating to 5G. And sales were good here in OSS and cloud infrastructure, not least. There was some decline of organic sales due to core sales in Northeast Asia coming down somewhat, but gross margin stable 38.1%. And I think what we see now is the continued impacts from cost reductions and efficiency gains in Digital Services, and that continues. We're working on the rationalizing the portfolio on the legacy side and reinvesting that, part of it at least, into the new 5G cloud-native portfolio.Yes, 10 contracts remain after the critical ones. All the other ones have been handled now according to plan. And I just want to highlight here when we look forward that we, of course, are very committed to the target of low single-digit operating margin for 2020, but it might not be a linear journey through the quarters here. It can vary between the quarters, of course, depending on sales mix and business mix, et cetera.Okay, Managed Services, and I'll speed up a little bit. Sales SEK 7 billion in the quarter, relatively flat, if you adjust for FX but with an improved gross margin year-over-year. This is fundamentally a stable business in Ericsson, but we can have some fluctuations in margin between the quarters due to the level of add-on sales, for example, that we deliver to customers and the timing of costs. So gross margin declined a little bit because of that, but full year, you should look at the full year here, I think, 6.3% operating margin. And this is even excluding a positive one-off we had in the first quarter then, and even this number is fully in line with the 2020 target for profitability.Okay, Emerging Business and Other. We have some extraordinary items, and we have described them before. It's the provision release and the ST-Ericsson legal wind-down, but if we exclude those special items, we see that this segment has improved its performance in 2019. We see organic growth and reduced losses both full year and in the fourth quarter. So we should bear in mind also, when we look at organic growth, we have adjusted not only for FX but also for the 51% divestment of MediaKind. We talked about strong momentum in the third quarter in the investor update. This continues. So sales growth in IoT almost twice the market growth, and now have more than 5,000 enterprises on the IoT platform. And so this is going well and right in line with our strategy. Finally, we have iconectiv. That's our software-based number portability solution that also continues to deliver profitable growth in both the fourth quarter and the full year.OpEx, R&D and SG&A here. In R&D, obviously, we continue to focus investments, 5G, cloud native, AI. And you see how R&D has shifted here between the segments. Well, we're investing in Managed Services and Networks and reducing the other 2 segments. In SG&A, in the middle, you see here the one-off item of SEK 0.2 billion when it comes to customer financing and then the SEK 0.4 billion which is around the corporate projects for the items that we have talked about earlier here. Of course, there is also a negative FX element on both R&D and SG&A worth keep in mind. On the right side, you can look at the graph here showing the yearly development of R&D and SG&A. You see that SG&A is down about SEK 1 billion per year, so obviously lower absolute amount but also lower percentage of sales; and R&D, meanwhile, up in absolute money terms, which is part of our -- key part of our strategy, I would say, but stable or even down in percentage.So for 2020, we do expect some higher operating expenses than in '19, and this is driven by these investment areas but also the fact that we have included the new Kathrein business. Of course, the ambition, at the same time that we have is to grow top line more than expenses. In other words, expenses as a percentage of sales should come down.Okay, free cash flow, quickly. I think we have said most of it already but coming in at 4x better than 2018 if we adjust for SEC and DOJ. We have had very strong focus on working capital efficiency again this year. I must say it has yielded a good result, good cash collection, et cetera. And working capital days down, now down to 75 days, which is the lowest I can remember.We end the year with SEK 34.5 billion in net cash and more than SEK 72 billion gross cash. So that's supporting one of the fundamentals here in the strategy to provide resilience for our company.Okay. So then to our planning assumptions here, and I really want to refer you as usual to the full report but to mention very few ones here. Dell'Oro, which we listen to when it comes to the RAN market estimates, estimates that, that market will grow by 4% in 2020. And '19, they have estimated it grew 5.5%. So our Networks business grew a bit faster than that in 2019.For sales in Q1, our average sales here is -- when it comes to seasonality is minus 25%, but it's worth considering that Q4 was impacted by the U.S. uncertainty we talked about. So the base is lower, meaning that the seasonality effect into Q1 should be somewhat better, a lower negative percentage then.IPR. We have signed a couple of new IPR contracts during the year, so the new base is SEK 10 billion, if we look at the contract stock we have, compared with the SEK 9 billion we -- as mentioned before. We also talked about Kathrein quite a lot, the net impact here, obviously gradually improving during the year, but still we expect a loss, that to be loss making for the full year.And then OpEx finally. Typically, we see a decrease here in between the quarters, Q4 to Q1. Last 2 years, average decrease was SEK 2.3 billion, but as we have said several times, we expect somewhat higher level then compared to 2019 this year.So that is it from me. Thank you so much. And I hand back to you, Börje.

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

Thanks, Carl.So closing. We launched our focused strategy in 2017 with the ambition to build a stronger Ericsson longer term. The first ambition was, of course, to turn around the company and return to growth, and we can now see that the increased investment in R&D is paying off. We've established ourselves as a leader in 5G with 79 commercial contracts and 24 live networks across 4 continents. We continue -- our ambition is to grow faster than the market and we continue to see faster growth. And we're winning contracts here based on technology merits, which has allowed us to maintain a solid gross margin.During the quarter, we've been able to reach an agreement with the DOJ and SEC. And with this agreement, it allows us to move forward building Ericsson with a focus for the long term. So we continue to increase our investment to ensure that we have a compliance program that is fit for purpose, and we are fully committed to our 0 tolerance policy and building a compliance program that's world class. So it includes work on changing our culture, updating processes, improving third-party management, vetting of senior executives, et cetera.The Board proposes to increase dividend to SEK 1.50 per share, reflecting a strong confidence in our strategy and ability to deliver on our financial targets.So we will keep focusing on building a stronger company longer term. We will make the tradeoff to long-term perspective for a short-term gain. Having said that, we are comfortably tracking towards our financial targets for 2020 and 2022.Thank you.

[Peter Nyquist, VP & Head of Investor Relations]

Thank you, Börje.So by that, we are now ready for the Q&A, so operator, I invite you to open that session, please.

[Operator]

[Operator Instructions] Our first question comes from the line of Edward Snyder at Charter Equity Research.

[Edward Francis Snyder, Managing Director and Principal Analyst]

I had a question about the U.S. markets, especially as regards the T-Mo/Sprint merger, which I would expect should be decided within the next month or so. If this should be -- if they should get approval for the merger, how do you see that impacting CapEx spending? I know it's been kind of put on hold, but if it does get approved, they're going to change plans on how they're going to deploy especially 5G and Band 41, et cetera. So one, how long do you think it will take to return to a more normal CapEx profile for that firm? And two, what is -- what happens with the margin profile of your business in North America when we start seeing more aggressive build-outs in the, I'll call it, sub 6, for lack of a better word? But AT&T has been talking about deploying on FirstNet, and then T-Mo would go on Band 41, but if that becomes a reality and we start seeing 5G equipment actually and bands deployed in the infrastructure, what does that do to the margin profile?

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

The -- as we said, the merger, the announced merger, has impacted Q4, clearly, but I would also say that what drives CapEx need in this industry, it's really a couple of things. One is, of course, the technology shift from 4G to 5G and we're in the beginning of that. The second one is the data growth, so the underlying need to invest in capacity hasn't really changed. So we don't really see short term that -- it's more important that the outcome is resolved. And whichever way it goes, we believe that reduced uncertainty will actually lead to spending because there is a need to do that. But of course, the investments will vary depending on the outcome, so that's why it's very hard to speculate about. So let's see where that brings us. If you look at the margin profile, we have -- and we've talked about this for quite some time. We have tried to make Ericsson less exposed to our geographic mix and mix between markets and mix between technologies in that sense and business segments. And I think when you look at the fourth quarter, you see a unusually low North American share. And we still have a -- sequentially a strong gross margin, so I think it indicates that we have a much less geographic mix or business mix exposure than we've ever had in the past. So that's what we are going to continue to work on because a resilient company has less of those, I don't know, variability depending on mix.

[Peter Nyquist, VP & Head of Investor Relations]

Okay. Are you happy with that, Ed?

[Edward Francis Snyder, Managing Director and Principal Analyst]

Yes.

[Operator]

Achal Sultania of Crédit Suisse.

[Achal Sultania, Director]

Just, well, a couple of questions. First, on the Kathrein. Obviously you're losing a lot of money right now, SEK 200 million gross profit loss, SEK 500 million EBIT loss in Q4. I'm just trying to understand what's the path and the timing of trying to get this business back to profitable levels. Is it about -- more about the new product launch? Is it about trying to launch those new products with the antenna systems as we go into 5G? Can we actually expect that business to be breakeven by the end of this year? And then secondly, on the OpEx side, can you help us understand? When you talk about slight increase in 2020, what is the right OpEx base we should use for 2019? Because there have been a number of moving parts, one-off items in 2019. So just trying to get a sense of what are the puts and takes for 2020 OpEx.

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

Yes. If we start with Kathrein, I'll leave Carl to comment on the OpEx. But with Kathrein, it's a couple of effects we've had during the fourth quarter. So when we took over the -- or we took over the business, we didn't have the permits to operate in the factory. So we had -- we have actually stopped supply in the beginning of the quarter, and that's what you see -- the effect of that, you see in gross margin. And then we will always ensure the safety of our -- of the people working for us. So for us, we did not want to operate the facility without fire permits. So that's one effect we had in Q4. Then -- so -- but that, you just keep that in mind. We also see that Kathrein was impacted by the uncertainty in the U.S. as well. So -- and you should put that aside and so that was what we saw in gross margin. When we now move into 2020, we expect to have a loss for the full year. And we do that because we are investing in building a strong road map within antenna and within a bigger product offering, so you will see us gradually improve through the year, but the year will overall clearly be negative. But we're establishing a very strong competitive position and competitive offering in antenna solutions. It's probably going to take 12, 18 months before we're there, but that's the time we are working according. And we think this is going to be even more important in the 5G world, when we can offer fully integrated site solutions. On the OpEx?

[Carl Mellander]

On the OpEx, yes. Achal, I can take that then. So I mean, as you know, we don't guide on OpEx typically, but we have said now that if you start with the baseline for 2019, it's about SEK 64 billion or so. We are saying that we will increase that a bit. And of course, the ambition here is to grow the top line more, as I said, in order to decrease the percentage of OpEx to net sales. But some of the moving parts, as you asked about: I mean we do have Kathrein, obviously, brought in, and both SG&A and R&D comes from there. And then we have the 3 areas that we talk about here, digitalization, which will yield return longer term, of course, in a more efficient enterprise; and also compliance; and security. So I would say, I mean, we -- obviously, we work with constant efficiency measures as well to be as efficient as possible in the SG&A side. In R&D, it's also about improving productivity, not necessarily decreasing the amount of investment there, because I think definitely we have proven that the investments in R&D have yielded result and strongly improved the gross margin and competitiveness. So we will manage it in a good way all within the 2020 targets.

[Peter Nyquist, VP & Head of Investor Relations]

All right. Achal, are you happy with that?

[Achal Sultania, Director]

Yes.

[Operator]

The next question comes from the line of Daniel Djurberg of Handelsbanken.

[Daniel Djurberg, Research Analyst]

First, congratulations. It's strong cash conversion here in the quarter and then also on the improvement in Digital Services. Just a short follow-up on Kathrein. Should we expect, given what you've stated recently, just that H1 will be slightly better? Or will it get even a bit worse, then getting better second half? That was the first question.

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

Yes, we should. We -- the -- this is a gradual process. So what we've seen during Q4 is this loss of production but also investments in the product portfolio. Investments in the product portfolio will clearly continue. So the ambition is to get back more to normal production. We think we are going to focus the product portfolio and invest for the future. And that's going to carry some costs throughout the year, with a bigger loss first part of the year than the second part. So we should see, you can probably assume, similar to Q4, give or take.

[Daniel Djurberg, Research Analyst]

Perfect. May I also just ask you about China and the 5G procurements? You've commented about the initial launches of 5G impacting growth in the area. Can you say anything about what you'll expect for the 2020 uptake? And also if you have seen anything on the market share, so far, would be great.

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

We have -- the procurement in China has not been concluded. So we have -- and we don't know when it will be, so it's a bit hard to speculate, but what I can say is we have -- our ambition is to strengthen our position in 5G then 4G. And that ambition, where we have and we're going to continue to focus on delivering on that.

[Daniel Djurberg, Research Analyst]

Perfect. And just short...

[Peter Nyquist, VP & Head of Investor Relations]

[ You got it ], yes?

[Daniel Djurberg, Research Analyst]

Okay. I will come back in line.

[Operator]

The next question comes from the line of Amit Harchandani of Citigroup.

[Amit B. Harchandani, Vice President and Analyst]

Amit Harchandani from Citi. My question really goes back to the resilience of the Networks' gross margin that we saw in Q4, which is, I guess, particularly noteworthy given the lower contribution from North America. For the full year, your Networks' gross margin was, I believe, around 41.8%. You've talked about -- at least you have referenced Dell'Oro talking about the market growing 4%, so there should be some leverage coming through for you on the top line. Is it a fair assumption to make that you will be able to manage the impact of strategic contracts? And given the growth in the RAN market, your gross margin for Networks should at least be flattish year-on-year in 2020? Or put another way, how would you advise us to think in terms of gross margin evolution for Networks over the course of 2020?

[Carl Mellander]

Shall I take that?

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

You take it.

[Carl Mellander]

But I think what we have shown now during Q4 also is that we are able to compensate for strategic key contracts with Other operational leverage. We don't expect that to dramatically change. Of course, we are fully committed to the targets that we have set up, including then the bottom line of 15% to 17%, and we will deliver on that. There are puts and takes there with strategic contracts and China, but we are also working on improving obviously the underlying operation in Networks. So that's what I would say on...

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

Yes. And I would say what we do now is we're also working on changing the way we work in the company and improving our ways of working through digitalizing the company more than in the past. That should -- the whole ambition with those investments is actually that it should lead to efficiency gains and lower cost levels in the future. So we're taking some costs during Q4 in order to deliver those benefits '20, '21 and beyond. So when you look at 2020, you can -- as Carl described, I think it's a good way to think about it, but longer term, we should see a lower ratio of OpEx to sales and a strong gross margin. And I've said it before. Gross margin is the best indication of a competitive product portfolio, so that's why we -- the -- it's a very important metric for us to follow. So of course, we're -- it's we are happy to see that we can reduce some of the geographic mix and, in addition, see a good gross margin despite taking some contracts with a challenged short-term margin in there. But they will contribute to 2022 and beyond, so we feel very comfortable about -- for the 2022.

[Peter Nyquist, VP & Head of Investor Relations]

Okay. You're good with that, Amit?

[Amit B. Harchandani, Vice President and Analyst]

Thank you, Peter.

[Operator]

The next question comes from the line of Johanna Ahlqvist of SEB.

[Johanna Ahlqvist, Analyst]

Yes. Maybe 2, if I may. The first one relates to OpEx again. I'm just trying. You mentioned that the base is SEK 64 billion. And I'm just trying to understand the magnitude of the OpEx increase because you have some one-offs in 2019 and just sort of putting back those one-offs would imply an increase of at least SEK 1 billion. And then adding more costs for Kathrein to that would get us to SEK 2 billion higher OpEx, so I'm just wondering. Are you really expecting an underlying increase in OpEx? Or are these sort of the one-off effects not to be there anymore and the addition of Kathrein? Or how should we think about it? Just to get the magnitude. That's the first question. And if I may, I have another one after.

[Carl Mellander]

Sure. Okay, we'll start. I mean I will say we -- I mean we are also doing efficiencies, of course, to deliver what I said before. And there will be an increase in absolute number, but -- and of course, there are one-offs included, fully aware of that, in the 2019. And there will always be one-offs, but that's not really what was there, of course. So there -- essentially, there will be a certain increase because of the investments and because of Kathrein, but again, thanks to the efficiency measures we are taking, we are aiming to reduce the percentage of net sales. And yes, that's what I can say.

[Johanna Ahlqvist, Analyst]

Okay. And my second question, if I may, was just on gross margin again because -- are you -- given the fact that you expect a higher OpEx level for 2020, I guess you need to feel pretty confident in the fact that you can keep the gross margin on fairly the same levels as 2019 for the group. So I'm just wondering. How big a negative impact do you expect we will incorporate from China? Is it a negative initial gross margin, or is it just a low initial gross margin? Because I guess that will have an important driver in either way.

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

Johanna, it's a great question. We cannot -- it's very hard to comment on China yet because we don't really know what market share we will get, what prices will be, so we'll have to come back on that. Of course, we factored in costs. When we guide for 2020, we have made certain assumptions that include costs to -- that affects gross margin negatively but still reaching guidance. But depending on what the outcome will be, we cannot comment. So a realistic case based on increasing our market share in China will have a negative effect on gross margin. We factored that into the guidance for 2020.

[Operator]

Fredrik Lithell of Danske Bank.

[Fredrik Lithell, Senior Analyst]

Many questions have been answered, but on the cash flow generation, you have improved; many of your metrics worked well with the working capital metrics in the year of 2019. Are there still a lot to do for you there? Or do you see that you have sort of reached a level where it's difficult to squeeze any additional out of those, so if we sort of take the operational size apart?

[Carl Mellander]

I think we have made very big strides actually on working capital during this year. We continue with that, definitely. And there is more to do. It's about lead times in projects; contract delivery; also on terms and conditions; and also the cash collection machinery, I would mention, which has been very effective during 2019. And that will certainly continue as well. So yes, the effort is 100% on to continue to deliver good capital efficiency. And of course, in a growth scenario, what we'll try to do is to still keep working capital at bay, if you like, even during growth, but of course, that puts another challenge into the mix if the whole business is growing.

[Fredrik Lithell, Senior Analyst]

Okay. And maybe a question for Börje then on China. Again, I know it's difficult to answer, but sort of when you think about this situation with the initial phase which we have seen many times before with pressure on the margins when you roll out, what sort of time frame are you expecting that to be under? Is it going to be a year or 2? Or how do you sort of see that playing out? If you would say that it starts now, would it take a year or 2? Or how do you sort of think about that?

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

It's very hard to say, in reality, how long the rollout will be, but if you look at the -- if you think about 4G, it took a few years to build out a complete nationwide coverage. So you can probably assume that this is going to have something similar, but it's very hard to speculate. What we have done is we have based a case on the historic experience, and you've seen the way we said in 2017. I think it's the same thing now. We have factored something similar in, and then we'll have to see where it comes out. And we'll hope, of course, we can gain market share, but we will see.

[Operator]

The next question comes from the line of Jörgen Wetterberg of Nordea.

[Jörgen Wetterberg, Senior Analyst of Telecom and IT]

So a quick question on the Digital Services contracts. You're right that you have some pressure from some continued impact from the BSS strategy. And we know that you have these major troubled contracts that you took provisions for last Q4 with 0% gross margin. When can we expect those to kind of go away? And how should we think about relief on gross margins from those in 2020?

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

Some of these contracts are actually very long. They're actually -- it's -- so even if we deliver and convert them into, call it, revenue-generating contracts, there will be a margin drag for a long time. They are -- some of them are even 10 years, so these are going to have an impact quite a long period of time. Our ambition is still that we will see Digital Services be profitable this year, low single-digit margins; and then reach double-digit margins in 2022. That is including a drag from those long-tail contracts. So there is -- we've said this before. I think the execution in Digital Services has always been focused on establishing a competitive product portfolio longer term, and that's why we have said the improvements come gradually. And of course, that factors in the drag from some of the contracts which will live there for another decade. So I think, over the last few quarters, you've seen us systematically deliver on that, and that's something we will continue to do. Then I -- you can always hope for some of these contracts to generate additional sales, additional revenues, as you have a footprint depending on how the customer scales their business, et cetera. And then the margin profile can change, but as of now, we're focused on delivering on the plan we've put in place.

[Peter Nyquist, VP & Head of Investor Relations]

Is that good?

[Jörgen Wetterberg, Senior Analyst of Telecom and IT]

Okay.

[Operator]

Stefan Slowinski of Exane BNP Paribas.

[Stefan Julien Henri Slowinski, Research Analyst]

I've just got 2 quick ones on cash. Maybe, the first one, for Carl. You had SEK 18 billion of free cash in 2019, about 8% of revenues. Can you help us understand more the outlook for 2020? We've got the restructuring guidance you've given, but should we expect any other significant changes in CapEx or working capital movements? Do you need to increase inventories, for example, to prepare for China? Anything else that we should expect to impact cash flow in 2020?

[Carl Mellander]

No. As you know, and we talked about this at the investor update, we have provided this illustrative bridge coming from a 12% operating margin, which is the 2022 target, and down to 8%; and describing then how the various components between will impact. And I think we stick to that. Well, now we were very successful, I would say, in 2019 in delivering a good cash flow. So we -- on those parameters that we mentioned in that bridge, we overperformed on several, not least on working capital. I think in that bridge we put working capital as stable in absolute -- or in percentage, I should say. So it's sort of neutral on working capital. I think that's a decent ambition to have going forward. When it comes to CapEx, as you asked, I mean, no major shifts. We are investing in the U.S. production, for example. So that will be in small variations there but nothing major to mention. We have a very big focus on generating cash flow, and I think that's -- we see the result of that in 2019. And so the whole organization is much more geared towards producing cash flow, and that includes working capital but also discipline in capital in general and in both allocation and spending on these various items. And we will continue to work on that. That whole area also, I should say, is supported by the incentive schemes that we have in the company, so that's also giving a lot of result actually, where we have working capital, we have cash collection, we have economic profit, which is a value-creation metric then for most people with short or -- short-term incentives. So that certainly helps us then. It's a big focus area.

[Stefan Julien Henri Slowinski, Research Analyst]

Okay. Maybe just to follow up…

[Peter Nyquist, VP & Head of Investor Relations]

Great. And your second question?

[Stefan Julien Henri Slowinski, Research Analyst]

Yes, just a follow-up question, maybe for Börje, on that, which is with the cash flow. I mean you've got the SEC fine behind you. Most of the major restructuring has been done, and you have this net cash position that it could be as high as SEK 50 billion by the end of this year, even after paying the dividend. So is there more you can do to optimize the balance sheet? And do you need to have SEK 50 billion of net cash?

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

It's a better problem than the opposite that we had, I think in 2017. Everyone told us we needed to raise equity. So the -- we will come back on this. I think it's important for us to have a strong financial position given the industry we're in. And we see that when we meet customers, when they look at our long-term plans and they look on our ability to be a long-term competitor, they look at our financial position, so it is important. Maybe we can do something on that. It's something we haven't looked at right now. We've been focused on making sure we get the business in much better shape, and then we can take the next steps. So let's come back and discuss that at a later point.

[Peter Nyquist, VP & Head of Investor Relations]

Thank you, Stefan. Realizing that we have a long line of questions coming up, I would actually now -- we will take the last question. [Operator Instructions]

[Operator]

And that question is from the line of Peter-Kurt Nielsen of ABG.

[Peter-Kurt Nielsen]

If I can just return to the OpEx and the decision to invest in the digitalization of business processes. I have -- I don't recall. I haven't heard you speak of this before. Obviously, one of your competitors has spoken of the need for similar investments. Could you perhaps discuss briefly what has driven your sort of decision to invest in this, the need? How long will this investment be? Is it a 1-year horizon? And is the impact which Carl illustrated for Q4, I think it was minus SEK 400 million, roughly sort of a good guide for what should -- we should expect in the coming quarters?

[Peter Nyquist, VP & Head of Investor Relations]

Thank you, Peter-Kurt.

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

Yes. It's these are -- if you think about them, it's actually that we increased cost level short term. That should result in lower cost level over time. That's what we do -- that's the reason why we do it, and it includes a couple of different things. So it's a number of different projects, but we feel that we need to automate a lot about our own order processes, visibility of customer orders, the way we run projects. All of this should result in efficiency gains down the road. And that's what we invest for, but the reality is, when we do these investments, we talk about them in the light of serving the customer in a better way. It's all about making sure that the customer gets the service, the customer gets the delivery on time, the quality on time, right the first time, et cetera. And why haven't we started doing it before? Well, we said that, first, let's get our basic processes in order before we automate them. And we felt, during the year of 2019, we got the house in order and we got the business in shape, so we said we can, during the year of '19, take the next step and see if we cannot get further efficiency gains and kind of improvements through digitalizing our business. That's why we took the decisions during Q4 -- or during Q3 and Q4. Then going forward, you can probably expect a similar level as we had in Q4 and gradually see the improvements coming through towards the end of the year.

[Peter Nyquist, VP & Head of Investor Relations]

Thank you, Peter-Kurt. Before handing over for the conclusion from Börje, some practical things. First of all, we have our event in Barcelona for the investor community and all associable customers but -- on the 24th to 25th of February; and you can find more information about, on the website, how to join that. And secondly, this time, we only have one call and we don't have an afternoon call. However, this call will be recorded and posted during the morning on our web, so you can listen in again on that.So by that, I would actually leave over to Börje to conclude this call. Please.

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

So thanks, Peter. And thank you, everyone, for joining.So with the focused strategy we put in place, we now have a very strong underlying business. We took some investments during Q4 that we will see yield results in the future. And we see that we are comfortably on track to delivering on the targets we set for 2020 and 2022, but that is only a first goal towards building a much stronger Ericsson longer term.So with that, thanks for joining us this morning.

[Peter Nyquist, VP & Head of Investor Relations]

Thank you.

[Carl Mellander]

Thank you.

[Operator]

This now concludes our conference call. Thank you all very much for attending. You may now disconnect your lines.