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Earnings Call Transcript 2018-Q3

[Peter Nyquist, VP & Head of Investor Relations]

Right. Good morning, everyone, and welcome to our presentation of Ericsson's third quarter results. Special welcome to everyone who is joining us by webcast this morning. We will start off with a presentation by CEO, Börje Ekholm; and CFO, Carl Mellander. And after that, we will be taking questions. So with that, Börje, I will leave the floor to you.

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

Thank you a lot. So again, welcome, everyone, to our third quarter result. And I would say the third quarter just continued with the execution of our focus strategy, and we could continue to see progress on our delivery of that strategy. As you know, we launched the focus strategy last year, about 18 months ago, where we had a couple of key activities that we were pursuing near term. The first one, investing in R&D for technology leadership. So we have increased our commitment to R&D by recruiting 3,000 engineers roughly, that's spread across the world, part here in Sweden, but also quite a lot outside. We have also -- the next part was actually to take out costs and reduce our costs, to become much more cost efficient. That is something we have continued to execute on over the last year. As you all know, we have reduced our workforce quite substantially over this period, reducing the costs by more than SEK 10 billion on a run rate basis.And lastly, we needed to focus on our core activities. Again, that's what we have continued to execute on, focusing on the core contracts, on the core business, exiting some nonstrategic contracts and also reworking some unprofitable contracts. So overall, that strategy is firmly in place and we continue to execute on that.Let's hit on a couple of highlights then from the latest quarter. The first thing, and I think that's really important, 5G is becoming commercial and a commercial reality today. We see 5G today being commercially deployed in North America in networks that are taking in subscribers. So it's not a "what if and when," it's actually today. And this, we see traction around the world. We see North America, of course, pushing ahead very fast, today leading the way, followed by Northeast Asia where we also see a quite heavy push into 5G. And why is that? It's back to the first use case for 5G is really to bring down cost of data. It's a cost argument. 5G is needed for the operators to cope with the exploding data traffic. And we also see fixed wireless access, i.e., basically competing with other forms of connectivity into the home, and that's primarily what's launched today in North America.During the third quarter, we also see that sales has stabilized, and that's one of the efforts we have done over the past 1.5 years was to stabilize sales, and we actually see that we have returned to growth. It's modest, but it's nevertheless significant that we are, on an organic basis, growing today. That's despite headwind from contract exits and actually a part of -- type of business that we have been doing before that we're gradually exiting.More importantly, possibly, is that we're profitable. We're profitable -- a profitable company on the group level today again. That's driven by ERS penetration. It's driven by a strong product portfolio but, of course, also cost-out.So this is the first time since 2016 that we're actually profitable, so that's important. It's critical for us as a company. Profitability is the only way to be a truly sustainable company. Otherwise, you are never going to be long term. Digital Services, you know that's weak or has been. What we are working through here is we're getting back into gradual improvement. We're still not there, but it's gradually improving, and we see we're executing on the plan. We have challenges in large transformation projects, and we have taken a provision in the third quarter. In -- at this time, we also wanted to update you all on the developments that we know of today at the -- with the SEC and DOJ investigations, and I am going to come back. But as you know, we are voluntarily cooperating with the authorities in this investigation and we are now engaged in discussions on finding a resolution.So our strategy, we aimed at reaching a 10% operating margin in 2020 and 12% beyond that, and we see we're tracking well towards achieving those plans.So if we look at some of the numbers. Again, here, you can see that we are growing. We have slight growth, but we also see an operating profit of SEK 3.8 billion. I would also say what is important, we have continued to be tight and disciplined on working with working capital and cash flow, and we have a positive free cash flow during the quarter. If we look at the business. We see our Networks performing very strongly, with an organic growth of 5% and an operating margin of 16%. And that's on the back of very strong development in North America, of course, but it's a -- we see growth also in Europe and Latin America. So Networks performing well. Here, we, of course, suffer also, and Carl will describe that more, from provisions we needed to take to financing contracts in the Middle East.Digital Services, we are still loss-making, but we're gradually reducing the losses, and we are taking a provision this quarter that fully explains the lower sequential development of the gross margin. Managed Services profitable, actually, profitability above our 2020 target, and show a very good stability in the development. The reason behind the improved performance in Managed Services, it is the cost-out, focused on efficiency and service delivery, and the second is, of course, the contract review where we now are almost complete in reviewing all the 42 contracts.Emerging Business and Other, gradually improving. We see some positive developments. We are disciplined in the way we work here, but it's gradually improving. The key driver behind the improvement is iconectiv. If we then go to the market area, it shows a very clear picture. Strong growth in North America on the back of the 5G momentum. And I would say, here, it's increasingly difficult to separate between 4G and 5G, as our 4G hardware is fully upgradable to 5G. So the operators today modernize networks in 4G in order to capitalize on opportunities in 5G, and that's why we see a very strong development in North America. We also see good growth in Europe and LatAm, and you also a see very strong development there.Northeast Asia, suffering from lower 4G investments in China, but also slipping sales in Digital Services. The big red is Middle East and Africa, and that's truly an exposure to the political and economical uncertainty in the Middle East that's affecting us negatively. And the last region, Southeast Asia and Australia, slightly down because we ended some large rollout contracts in the third quarter of last year. So it's more tough comparable there. But overall, our sales on an organic basis grew by 1% first time in a number of years.So an update on the SEC and DOJ investigations. We have been voluntarily cooperating with the authorities, with SEC since 2013 and DOJ since 2015, in their investigation into compliance on the Foreign Corrupt Practices Act. And just to say that, that includes, of course, corruption, as the name suggests, but it's also books and records, internal controls. So it's a broader definition of FCPA.We continue to cooperate with the authorities, but the reason why we're here is that we have also seen now, when we do our own investigation and fact-finding, that we have breaches on our Code of Business Ethics. And therefore, we have reported that to the authorities and that's been part of the investigation. So we don't know how these discussions will go, how long they will take. But we do think it's likely that based on the facts that we're sharing, that we will have some measures taken, would be monitoring, could be other as well. It's unfortunate, I know that. You have probably a lot of questions, but we today cannot assess the magnitude. And that's also the reason why you don't see us take a provision today against that. This is also an ongoing matter, so it's very hard for us to comment on details in the investigation, and we will not do that, so also, that is unfortunate, but that's where we are. We felt we needed to share this with all of you anyway in order to be as open as we can.Of course, for us, ethics and compliance are very critical. It's not only what business we win, it's actually how we win. And we need to win based on our own merits and have that integrity in the way we operate. As a matter of fact, ethics and compliance, that's not a new thing here at Ericsson. It started really more than a decade ago. So 2004, we put a Code of Business Ethics in place. And since then, we've gradually improved our ethics and compliance program. Over the last 2 years, as you can see here, we have accelerated improvements. So for example, we brought in an external consultant in the end of 2016 that have advised management and the board and reviewed our historical compliance program and suggested improvements, changes that we need to do in order to be stronger. That's what we're working on, so we're continuously implementing these activities. And they include a couple of areas. It includes, of course, culture and people, but it also includes third-party engagements. It includes investigations and the whole compliance program. But it also includes, of course, control mechanism, how to make sure that we are in compliance. So you see us take a lot of activities here; they're critical in order for us to be world class also on the ethics and compliance.So before giving the word over to Carl, I would say we're on track on our strategic execution. We see our key areas improving as they should. Networks performing well, with ERS substitution up now to 86%. We see cost savings coming out in service delivery. But more importantly, we see the investments that we've made in R&D giving us a very competitive product portfolio, and there, we're performing well in the customer -- with our customers.Digital Services, we are gradually reducing the losses. We need to have focus on that. That's a big turnaround effort. We have reviewed today almost half of our, what we called, contracts that we have said we will address. And we said that half should be addressed by year-end, and we're well on track towards that. The reason why we are improving in Digital Services is, of course, the cost-out. We're taking out costs in common functions, as well as streamlining our R&D on the back of streamlining our product portfolio. Managed Services, I would say the contract review is today getting very close to done, and that has had a positive effect on the performance here. And -- but I would also say, most important on the improvement is actually the cost-out that we've done within Managed Services. So today, we have a solidly profitable Managed Services, performing well in line and even better than the guidance we set for 2020.And our Other, there, we have our media assets, as well as our emerging business. And of course, on media, we have partnered with OEP, transaction we expect to close by year-end. And the rest there is developing like it should, but on the back of primarily a strong iconectiv. And you all know that we will review where we are more in detail at the Capital Markets Day coming up here in a few weeks.With that, I give the word to our CFO, Mr. Mellander.

[Carl Mellander]

Thank you, Börje. Thank you so much. Good morning, everyone. Good to meet you all again. Let's look at the numbers per segment a little bit more then, and starting with segment Networks. And it's clear here that the momentum that we talked about already in the second quarter continues now. In second quarter, we grew by 2%, now 5% in Networks. That's strong, and we say that strategy is really biting, as Börje was saying. The investment in R&D is giving a competitive portfolio. It's really appreciated by the customers. But it's also helping us to take cost out, and this is what we see now both in hardware and services margins, that they are coming up, giving this good result on gross margin. The market mix is a bit favorable in this quarter, we have to say. Also, the business mix, where the data traffic again is driving a high proportion of software and capacity sales. But all in all, with an operating margin of 16% here, Networks is performing very well.Digital Services then. Here, sales declined 6%. On the other hand, we can also say that the decline is flattening out. It was 12% in the second quarter. And many parts of this business are moving in the right direction. That's quite clear. The new product sales is showing a stable number, which is good. And of course, this is really driven by the technology shift to virtualization, but also operators preparing for 5G. So you see the gross margin here improved year-over-year, but declined quarter-over-quarter. And here, this has to do with what Börje mentioned earlier, namely, the fact that in some digital transformation projects, we see cost increases. So we have had to make a provision now in the quarter of about SEK 0.5 billion, and that explains the sequential drop entirely in gross margin here. Of course, not satisfied with this development, and we are taking forceful action as ever to turn these projects around. But despite this though, as you can see here, of course, the operating income continued to improve. And again here, cost-out is tracking well, and the portfolio is continuously being optimized as well. And of course, we see a lot of efficiency happening, both service delivery, as well as in R&D here to keep improving the bottom line, which, as you see then, improved sequentially to SEK 1.4 billion loss.Managed Services reports another strong quarter. Sales down a little bit, but that has to do entirely with our strategic choice to exit out of some contracts, so that's going well. And Börje mentioned the number 40 out of 42 now concluded. But what is also good is that we are actually growing in Managed Services for IT and network design and optimization. Those areas are both showing growth in the quarter, so that is good. Gross margin improved significantly here. It's really the cost and efficiency measures that are showing themselves here. And automation is playing an increasing role, we will see more of that in the future. So good to record a positive operating income here for the third quarter now, stable sequentially.Emerging Business and Other then. Yes, here, clearly, iconectiv is supporting the P&L, both when it comes to growth and profitability. And this is the -- to repeat that that's the number portability contract in the U.S. that we started to deliver on in the second quarter. The media assets, both of them, both Red Bee and MediaKind, improved their performance year-over-year. And here, we continue to invest selectively, of course, in emerging business to make sure that we make the right disciplined decisions in the possible future growth areas. But all in all, gross margin, operating income as well improved both sequentially and year-over-year in this segment.So if we just back up for a second and look at the full P&L again then again, with the SEK 53.8 billion sales, and the gross margin just below 37% and then an operating income after -- or excluding restructuring of SEK 3.8 billion. But there are a couple of things that we can drill into quickly here. One is the operating expenses and then leading into gross margin as well. So if we look at SG&A to start with. As you all know, we announced after the second quarter that the SEK 10 billion program, cost-out program was finalized. We did that on time. Of course, it doesn't mean that cost efforts discontinue. On the contrary, we continue, of course, to take out costs and stay very disciplined on that. And here, you see the result on the SG&A line is then SEK 700 million of additional cost savings. This was then offset by -- partly by the revaluation of customer financing in the Middle East that we talked about, but also certain other factors, including, maybe to pick one, the cost for field trials related to 5G, which is a factor and will continue to be a factor, as we mentioned in the report as well. R&D, on the other hand, increased, also following strategy, where we continue to ramp up in Networks. But that is, as you can see then, offset by reductions in Digital Services in R&D. And of course, R&D is also one of the key elements here leading into a gross margin improvement. So if we switch to then to gross margin, you see, we improved gross margin on all segments. And if you look at the bottom graph here, we show the underlying gross margin, a fairly good illustration of the turnaround of our margin profile that we have seen now with now 3 quarters in a row, 36%, 37% in gross margin.I should mention again just to underline that we had some positive effects here in the quarter when it comes to the margin profile. As I mentioned, the market mix, as well as the business mix. We also had a catch-up effect in the IPR business, around SEK 300 million, which helped boost gross margin, following one signed contract with a partner there on IPR.When it comes to cash flow, also a positive story here. We delivered free cash flow before M&A of SEK 0.7 billion, which is then SEK 1.5 billion better than the same period last year, going from negative to positive. And year-to-date, we have actually delivered SEK 6.7 billion better cash flow than 2017, so this is developing well as well. And essentially, our balance sheet resilience remains. Clearly, you can see the debt maturity profile, nothing to worry about there. No maturities in 2018 or 2019. And we have a better and better net cash position. Our net cash is up to SEK 32 billion, which is an increase of SEK 8 billion from last year.So I will end on giving a little bit more meat when it comes to planning assumptions then, and we've said it a couple of times now. When it comes to top line, we should bear in mind the seasonality effect here which we don't expect to be as strong as earlier years. The reason for that is that North America is going so well and we are delivering on a fairly high capacity level already to North America. This will continue. I'm not talking about any slowdown, this will continue at this high pace, but we won't see the same uptick in Q4 as we have done some earlier quarters. The rest of the world is likely to, however, have the normal typical seasonality in the quarter.On the gross margin then, worth to consider a couple of factors. Of course, we continue cost-out. But again, the regional and business mix is something worth to consider as well when modeling gross margin going forward. And on the OpEx then, important to remember there the seasonal affect we typically have from Q3 to Q4. Normal seasonality is an addition of between SEK 1 billion and SEK 2 billion between Q3 and Q4 on OpEx. And 2017, we had some extraordinary items, but the underlying growth of OpEx was SEK 2 billion in 2017 as a reference.So I think that concludes this part, and I hand back to Mr. Ekholm. Thank you.

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

Thank you, Carl. So just to wrap up. We continue the execution of our focus strategy, and that's again investing for technology leadership. Technology leadership itself is important to serve customers, but it's equally important to bring costs down. So we leverage technology and the investments in R&D to bring out the cost of our products down and become more cost efficient towards our customers. We have also, over the last year, worked hard on our cost structure. Now it's all about making sure we institutionalize this, make it a continuous improvement and work on getting the most cost-efficient operation we can in the world. Where we are: strong product portfolio and great cost position, we're very competitive, and that's what we see now that we are. But we're going to become -- or we are really committed to hanging on to that advantage. We cannot give up. 5G becoming a commercial reality. It's commercially deployable, and you can buy a subscription today in North America. For us, leading into 5G is critical, so we continue to invest for 5G leadership, but we do that in our 4G portfolio that's already ready for 5G.The first use case, as I said, is going to be enhanced mobile broadband. That's because the operators need to deal with the growth in traffic. And in Europe actually, we clearly lag on the demand for data traffic compared to many other parts of the world. So for example, we're less than -- most European countries are way below less than half of what the demand is in India. So other parts of the world have a faster need for new technologies to cope with the demand in data. And that's why we see North America, as well as Northeast Asia, taking off. We are investing very intensively into artificial intelligence and automation for running the future networks of the world. We see that through investments in our Managed Services platform, for example, where we invest quite substantially in completely new offerings to the market where we can go in and run the network at substantially lower cost than before. So we have many very exciting offerings coming in terms of automating and making the networks more serviceable. So for us, you wonder, of course, why we have this picture, but you see you next to the hotel sign why the picture is there. So we have a product in all our pictures. So thank you all for coming.

[Peter Nyquist, VP & Head of Investor Relations]

Thank you very much, Börje. Don't leave. Carl, if you can also join us up here, and we're ready to take questions. And please wait for a microphone and then state your name and where you're from. So we'll start over there. Thank you.

[Johanna Ahlqvist, Analyst]

Johanna Ahlqvist from SEB. Two questions, if I may. The first one is related to competition. Maybe you can comment something partly on Samsung, now being one of the radio suppliers to AT&T, if you see any traction for them or do you expect any traction from them going forward? And secondly, also Huawei, of course, and [ sat-e ], do you see any traction that can benefit you in Europe in particular? That was my first question. And my second question relates to the DOJ investigation. If you can comment anything on sort of the scope of this investigation. What countries? What point in time did those particular events take place and so forth?

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

If we start with the first. The reality is we have competitors. We clearly fight that on a daily basis. What we do is really focusing on solving the customer need. So for us to provide the leading products into 5G is really, really critical. And you'll see now, we have announced a couple of contracts publicly. There are also other contracts which are not disclosed for reasons that our customers do not want to. So we are very comfortable about the competitiveness of our portfolio. Of course, Samsung is one competitor that has an offering. Huawei has also and Nokia has also. But we see that we have good momentum in our discussions with customers, and we see that we can solve their needs with our product portfolio. So we feel quite confident about that. On the DOJ and the scope and in time, what you -- it's very hard for us to go into any details, and I can understand that's unsatisfactory. But we -- the scope in geographies, we don't want to comment on. It covers a fairly wide scope. And at points in time, it dates back from before 2007 and onwards.

[Daniel Djurberg, Research Analyst]

Yes. Just a clarification on -- my name is Daniel Djurberg from Handelsbanken, by the way. A clarification on 2007 and onwards, you said i.e., that some of this new facts that you have handed over to the Department of Justice, in points in time, it's after 2017 -- 2007, sorry. And also, if you can say if you have any more -- any one employee that is involved in these -- within these new facts you have handed over to Department of Justice. That is my first question.

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

Well, as this is an ongoing matter, we will not go into any details. But you can also understand that it spans a very wide period of time. What I think is kind of good to know is that about 50 people have left us as a consequence of the investigations we have done. So trying to say that we have taken quite a lot of actions and we have done quite a lot of activities, but we also have shared the facts with the authorities, and now we need to see how we resolve that with the U.S. authorities.

[Daniel Djurberg, Research Analyst]

And then a question to Carl perhaps on the restructuring outlook for Q4. You have quite a wide range then, a SEK 1.9 billion range, I believe, coming up today between -- up to SEK 7 billion. So what do you see? I guess you should have -- from my point of view, it should be possible to narrow down then this a little bit. But any comments would be helpful.

[Carl Mellander]

Yes. Now we chose to keep the range SEK 5 billion to SEK 7 billion. And it depends a little bit on timing of certain actions there, but again, the cost-out program was finalized, the SEK 10 billion, but it doesn't mean, of course, that we have discontinued the take-out costs. And some of the cost-out activities are linked then to restructuring costs that might come in into Q4. So we kept the range to SEK 5 billion, SEK 5 billion to SEK 7 billion for the full year.

[Jörgen Wetterberg, Senior Analyst of Telecom and IT]

Jörgen Wetterberg from Nordea. I have 2 questions, if I may. First one relates to the sales in North America and the lower seasonality Q3 to Q4. You said you're already delivering at full capacity. Is the capacity -- your capacity the constraint, or is it the demand from the operators in reaching their CapEx guidance? That's number one. Number two is related to the EBIT improvement that you have in Digital Services. It's 1 percentage point, but it's still a long way to go from minus 16 to low single digit. Can you elaborate a little bit, if you can, on where that's going to come from, and more specifically, in Q4 and 2019?

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

If you -- if we start with North America. The customers -- there is also a capacity in the sense of starting the demand -- what drives the demand. It's actually the data, the consumption of data. That continues to grow very strongly. So the U.S. operators have a need to invest in capacity in the networks. That's unchanged. But it's also, when you make very big rollouts and capacity adjustments, you just get constrained how quickly that can be done. Tower, crews, et cetera, that's winter season. You can't install in north -- up northeast, for example, in December. There are certain things that structurally makes it harder to deploy networks during that season. So we see that is going to impact the seasonality effect we typically have seen in Q4, and that's our best estimate today. The reason for that is Q3 was strong. They're kind of ramping up earlier than normally has been the case. So it's -- I would say the demand situation is quite favorable in that sense. On the Digital Services, I think you -- the reason why you see a drop in gross margin is clearly related to our -- to the provisions we needed to take to a large digital transformation contract that was taken way back. And that is reason why we don't see as much progress as we should. At the same time, we see, if we look at the business Digital Services, we see that very large parts of the business like the packet core, like our OSS, it's developing very strongly and doing well. But we have some areas where we need to improve our profitability. Part of that is simply working through some contracts and some situations, and that will take some time. That's why we provided a guidance of low single digits 2020, knowing that that's going to take into 2019. But you see progress on the cost-out, so you can take comfort in that we are getting the right cost structure on SG&A and R&D, and then we're working to basically get through on the service delivery on some of the big contracts. Ray?

[Ray Le Maistre]

Ray Le Maistre from Light Reading. When do you expect to start to see commercial impactful revenues from 5G products? And when that starts, will the margins be higher because these will be software upgrades?

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

What you will see -- and I would say, with our products, it's increasingly difficult to make the distinction between 4G and 5G, because they are software upgradable to 5G. So today, to classify a network as maybe the first application is 4G, but it's really modernized in order to run on 5G. So what we see here is a quite -- I would say, that the demand for our products really come from the growth of data in the networks. That's translating into need to modernize the increased capacity in 4G. You do that, of course, with carrier aggregation, you do that with MIMO, et cetera. So you use technologies to cope within the 4G. But ultimately, you will need 5G to increase spectrum efficiency and get the lowest cost possible. And we have said we think the total cost of ownership, if you look at dollars per gigabit in the network, is -- compared to a 4G network, a simple 4G network to 5G network, it's a factor of 10. So you can come down 80%, 90% in costs with 5G for the operator. That's what's happening here. That's why today, to classify a product as 5G is a little bit challenging for us given our choice to make the hardware upgradable. Not everyone has the same.

[Peter Nyquist, VP & Head of Investor Relations]

We have a question up in the front here.

[Fredrik Lithell, Senior Analyst]

Fredrik Lithell from Danske Bank. Carl, maybe just a clarification on the planning assumption. You point out that last year, you had a sequential growth of 17 between the quarters. Is that the base we should view and argue about -- sorry, and argue about the lower sequential growth now than 17 or should we look at the 5-year average?

[Carl Mellander]

Yes. So the 5-year average I think is around 18 or so, and 17 was last year. We are looking at a lower growth rate than that.

[Fredrik Lithell, Senior Analyst]

Okay. And maybe Börje, if I could ask you on your OpEx and your drive for investments. How should we view 2019? And given the field trials is ramping up and everything, are you pushing even further on investing in R&D, so that should continue to ramp up in terms of costs, or are you on a fair level?

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

Yes. We're probably on a reasonable level now. You may see some small increments, but it's not -- it's -- we have seen a catch up, and that's what's been going on now, so that's why we have seen the ramp. All resources we have added hasn't been fully productive yet. That kind of starts coming now, so we see this level to be flattening out. That's kind of the honest assessment. Then on the -- it all depends on how the market develops, what will be the ultimate need for different products in different geographies, right? So there could be adjustments due to that, but normally, it should flatten out now. If you look then on field trials, our ambition when we put out the guidance was that we should be able to absorb that in our normal performance, but we wanted to say, we recognize that they're growing quite fast right now, but they're already incorporated in the results, so we're not going to separate them out in any way. But we see them -- at least, we -- our ambition is to absorb them. If they wouldn't be able to absorb them, we may need to comment again, but otherwise, they should be in the result.

[Peter Nyquist, VP & Head of Investor Relations]

Very good. I think we have time for one last question.

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

It's worth to remember that field trials, sometimes we think of them, but it's almost like a small European country in size. So it's worth to remember, they're pretty big when it comes to some of those big countries.

[Peter Nyquist, VP & Head of Investor Relations]

And on that note, I think we're going to finish here. And I'd like to remind you then of our Capital Markets Day on November 8 in New York. So hope to see you there. Thank you very much for joining us this morning. Thank you.

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

Thank you.

[Carl Mellander]

Thank you.