Ericsson Lm Telephone Co Q2 FY2022 Earnings Call

Hello, everyone, and welcome to today's presentation of Ericsson's Second Quarter Result 2022. Together here in the studio, I have our CFO, Carl Mellander; and our CEO, Börje Ekholm. As usual, we will start this session with a presentation of around 20 minutes, and then we will have the Q&A session. More details around that you will be able to find on our web page, ericsson.com/investors. During today's presentation, we will be making forward-looking statements. These statements are based on our current expectations and certain planning assumptions that are subject to risks and uncertainties. The actual results may differ materially due to factors mentioned in today's press release and discussed in this conference call. We encourage you to read about these risks and uncertainties in our earnings report as well as in our annual report. With that said, I would like to start with giving the word to you, Börje. Please, Börje.

Thank you, Peter, and good morning, everyone, and welcome to today's presentation. And a big thank you for joining us, of course. I'm pleased to present another quarter where we continue to see a strong business performance. We are growing, driven by the global rollout of 5G networks as well as market share gains. Today, we have a 39% RAN market share, and that's, of course, excluding Mainland China, and that's up from 33% in 2017. Today, 50% of the world's 5G traffic outside of China is carried over Ericsson radio networks, and 80% of the top 20 operators in the world are using our 5G Core. Fundamental to our strategy is technology leadership. And since 2017, we have increased our investments in R&D significantly, and we're committed to continuing this journey of innovation. This includes investments in our mobile infrastructure business but also developing a leading offering in the enterprise space. In the quarter, we announced some changes to our structure, and that will allow us to speed up and accelerate the execution of our strategy. With 5G, anything that can go wireless will go wireless. This puts Ericsson in a very good position as 5G is rolled out and transforms every sector of society. So now let me go through some of the key takeaways from the quarter. We see good business momentum, and our underlying business is developing well. We continue to drive improvements through the introduction of new innovative solutions and continue to improve our underlying operations. In the quarter, we saw organic sales growth of 5%, with gross income reaching SEK26.3 billion. This is driven by strong 5G momentum in North America as well as in Europe. Our EBITDA margin for rolling 4 quarters was 14%. That's tracking close to our long-term target of a margin of 15% to 18%, and that's a target we're committed to reaching in the next 2 to 3 years while we establish Ericsson on a stronger long-term growth trajectory. This is a testament to the hard work and commitment from our colleagues across the company, who have continued to deliver to our customers in spite of a very challenging supply situation, and a big thank you to our team out in the world. You all know the global supply chain situation remains really challenging, and inflationary pressures are significant. We're investing, and we have been investing, actually dating back several years, to derisk our supply chain to build resiliency. This has included creating a more flexible manufacturing footprint, but we have also invested in building buffer inventories. And this, of course, leads to a larger inventory situation in the company. Ensuring supply in a difficult supply environment is associated with extra costs. However, we see this as a key driver of our ability to actually expand the footprint and strengthen our scale. And from a long-term perspective, we believe this is critical. I remain convinced that actually lost sales cost more from a long-term perspective than carrying a bit of extra inventory short-term or for a few quarters. That's basically like an insurance premium for the future. So this ability to deliver despite a very challenging supply situation we believe is critical to establish a stronger footprint and thus a bigger scale, which will drive our long-term profitability. To handle these extra costs, of course, we're going to see compensation as contracts expire. But we believe that the key drivers to combat the cost increases will be to continuously launch new innovative products and solutions with new features as well as lower costs. And that's what we have used the last few years to turn around the company and we continue to use that in order to actually combat the cost inflation. We have continued to do that during the quarter. The gross margin came in at 42.2%, excluding restructuring, and that's lower than what it was last year, 43.4%. The decline in gross margin is largely attributed to lower IPR revenues in the quarter. That means we've been able to mitigate a large part of the cost inflation with the continuous improvement of the business as well as product substitution. IPR revenues are affected by several expiring patent license agreements that we are renegotiating, and also some other 5G license negotiations. And we're confident in our strong 5G patent portfolio, and we will seek to optimize the return from that portfolio. And here, we believe we're in a strong position to negotiate, of course, good future license deals. So we will seek the right deal rather than rush, as that may lead to slippage in time, because it's more important for us to have the right deal than do it quickly. Gross income improved by SEK2.4 billion, and EBIT by SEK1.5 billion compared to Q2 last year. We also continue to engage with the U.S. authorities, the DOJ as well as the SEC in relation to the 2019 Iraq investigation and the DPA breaches. At this point in time, we cannot assess how these matters will be resolved. We remain, however, fully committed to cooperating with the authorities as this process goes on. We also continue to increase our investments in ethics and compliance. Actually, a large part of the increase in our SG&A during the quarter is attributed to investments in ethics and compliance. We further need to make sure that we have integrity in all decision-making in the company, as well as we have a prudent approach to risk-taking and risk management in the company. And we believe that all of those investments that we are making in changing the culture as well as our processes and procedures will make Ericsson a stronger and more resilient company in the future. Let me now turn to the customer and market side of our business, where we continue to see strong traction across the business, with organic growth in 4 out of 5 market areas. Our strong momentum in North America continues, where sales were up 12% year-over-year, FX adjusted, of course, and that's driven by continued high demand for 5G solutions in Networks. The U.S. customers continue to be at the forefront of 5G deployment and the introduction of new use cases. Overall sales in Southeast Asia, Oceania and India increased by 6%. This was driven by Networks and Digital Services, where we saw market share gains. Sales in Northeast Asia had a small decline of 1% year-over-year, that was mainly due to the timing of 5G rollouts. In the Middle East and Africa, sales increased by 8% year-over-year, that's predominantly driven by Africa, with 4G rollouts as well as software upgrades in digital services. Overall, we continue to see very encouraging momentum in the market. Finally, in Europe and Latin America, sales increased by 4% year-over-year, thanks to growth in Europe, while Latin America was stable. Overall, we continue to see very good momentum on market share gains in Europe, with Networks showing double-digit growth despite sales being affected, of course, by the invasion of Ukraine and Russia, which impacted sales by SEK1.2 billion or lost sales during the quarter. So let me now move over to our strategy, which is based on leadership in Mobile Networks as well as a focused expansion into enterprise. In the quarter, we took a key step to accelerate our strategy execution by introducing a new group structure. On the Mobile Networks side, we've introduced a new segment, Cloud Software and Services, by merging Digital Services and Managed Services. This will allow us to capitalize on the convergence of Cloud Software and Services and grow our core mobile infrastructure business. We remain very committed to turning around the business as quickly as possible in that segment to support us in reaching the long-term group targets. On the Enterprise side, we formed a new segment, Enterprise Wireless Solutions, which is the combination of Cradlepoint and Dedicated Networks. Cradlepoint continues to strengthen its position in the market and shows growth in excess of 40% this past quarter. The Enterprise segment will also include the global network platform, which we believe will drive a paradigm shift in the industry. The network will be a horizontal platform whose capabilities will be exposed, consumed, and paid for through global network APIs. The global developer community can therefore start to innovate on top of the network and leverage all the capabilities of the network. This will be very important in establishing 5G as the strongest innovation platform the history has ever seen. We believe this will inspire innovation. Most importantly, it will give our customers, the service providers, another avenue to monetize the network investments. We are working very closely with front-runner customers, and we see strong responses from our customers supporting the introduction of the global network platform. The intended acquisition of Vonage is an important building block to execute on the global network platform, and we are working to secure approval and close the transaction before the end of July. Our strategy builds on technology leadership, and we continue to invest in R&D so we can launch new and innovative products in the future as well. This includes investments in our Mobile Networks business as well as in Enterprise, and we will spare no resources in strengthening our position in those areas. Now, let me give the word over to our CFO, Carl Mellander.

Thank you, Börje. Excellent. And good morning, everyone. Thanks for taking the time. First of all, I wanted to say that this will be the last quarter we report according to the existing current structure of segments. From the Q3 report, we will report in the new structure with the 4 segments: Networks, Cloud Software and Services, Enterprise, and Other. We will provide a restatement from first quarter 2021 until second quarter 2022 and also for the full year 2020 in this new structure, and we will do that in September, well in time for the Q3 reports. If we look at the numbers, starting with net sales, the net sales amounted to SEK62.5 billion, with organic growth in 4 out of the 5 market areas. We achieved organic growth of 5% despite a couple of items that Börje touched on, including the suspended business volume in Russia, which accounts for a SEK1.2 billion top-line drop, and also the IPR revenue, which is SEK0.9 billion lower year-over-year. This growth was really driven by 5G deployment in two of the largest market areas we have, namely North America growing 12%, as you saw, and Europe and Latin America growing 4% organically, especially driven by Europe. Reported sales grew by 14%, and we have quite a strong FX tailwind here due to the weakened Swedish krona. IPR revenue, as mentioned, was SEK1.4 billion in the quarter, decreased from SEK0.9 billion, as said. This is in line with the guidance we provided in the Q1 report for Q2, when we said that we would end up between SEK1 billion and SEK1.5 billion in the quarter and we came out at SEK1.4 billion. The same guidance is maintained for the third quarter; that's important to say. Of course, the actual outcome will depend on the timing and terms and conditions of any new agreements. Gross margin, excluding restructuring, came out at 42.2%. I will drill more into gross margin in a moment, so we can continue talking about the R&D expenses. R&D amounted to SEK11.5 billion, an increase of SEK1 billion, of which around 40% relates to FX movements. We have increased R&D mainly in Networks. Two areas to mention are the Ericsson Silicon, which is the next-generation ASIC, and Cloud RAN. The silicon piece is to enable industry-leading radio performance and energy savings, not least, while Cloud RAN will provide more flexible deployment options for our customers. We will continue with this increased R&D for value-creating purposes. SG&A also increased SEK0.9 billion to SEK7.9 billion. A portion of that is linked to FX, of course, but other than that, it's related to legal and compliance costs and expenses we have. EBIT, excluding restructuring charges, was SEK7.4 billion in the quarter, a year-over-year improvement of SEK1.5 billion, corresponding to an EBIT margin of 11.8%. This is a year-over-year improvement of 1.2 percentage points. Further down the P&L, net income came in at SEK4.7 billion in the quarter versus SEK3.9 billion last year, a result of improved EBIT. I should mention that this is despite a more negative finance net driven by FX hedge results. Free cash flow came in at SEK4.4 billion versus SEK4.1 billion a year ago, despite a significant buildup of inventory to secure deliveries to customers, as Börje outlined earlier. EBITDA is now the key metric for profitability going forward, given the long-term target we have of 15% to 18%. Excluding restructuring on a rolling 4-quarter basis, it came out at 14.1%. Let's have a look at gross margin and drill into that a bit more. On a rolling 4-quarter basis, gross margin, excluding restructuring, is at 43%. The improvement since the beginning of 2020 is driven by the investments in innovation in R&D that we have made since we started in 2017. This has enabled better product offerings and features, which we continue to do in this inflationary environment. Despite the increase in market share, which sometimes can dilute margin, we've been able to absorb a lot of the cost pressure with higher sales on one hand and the improvements in our business on the other. Digital Services gross margin came out at 39.9%, affected by initial deployment costs for some of the cloud-native 5G Core contracts. Managed Services, on the other hand, saw gross margin increase by 4 percentage points to 23%, driven by network optimization business growth and variable sales in Managed Services. For Managed Services, the rolling 4-quarter EBIT margin was 9.5%, within our set target of 9% to 11%, two quarters ahead of plan. Next quarter, we will report according to the new structure with Digital Services and Managed Services combined in the segment Cloud Software and Services. Emerging business and other gross margin was 35.8%, with a year-over-year decline due to Cradlepoint, mainly on an accounting basis due to a positive one-off effect last quarter. Overall, in the actual business, Cradlepoint performs well with growth over 40% and a gross margin well above the group average. Now, moving to cash flow before M&A, SEK4.4 billion versus SEK4.1 billion a year ago, driven mainly by EBIT improvements. We focus a lot on cash flow in Ericsson, and the ability to deliver SEK4.4 billion despite proactive supply chain investment is a significant reflection of the team's efforts to generate cash flow. You can see that in the operating net assets due to inventory. But it is offset by very strong customer collections as well. Based on current visibility, we expect inventory levels to gradually reduce towards the end of the year. This leads to a solid cash position ahead of the Vonage acquisition. Gross cash now is a bit more than SEK100 billion, and net cash is at SEK70 billion. When we evaluate free cash flow before M&A, on a rolling 4-quarter basis, we achieve our long-term target of 12%, which we are now at. With that, I hand it back to our CEO, Mr. Börje Ekholm.

Thanks, Carl. Now to sum up, we had another quarter with solid business performance. We're able to largely offset, as Carl described and I mentioned in the beginning, the challenging supply situation we're facing as well as cost increases through our investments in the geo-resilient supply chain and underlying margin improvements that come from product substitution and gradual improvements of our operations. We continue to believe that innovation is the most important way and the best way to offset inflationary pressures. Of course, we're also going to look at adjusting contract terms as they expire. We're well positioned to capture the opportunity of digitalization of consumer enterprises and society based on wireless connectivity and 5G. 5G is, by far, the fastest scaling mobile technology ever, though global penetration is still in an early phase. Mid-band penetration remains low worldwide. We foresee that global 5G build-out will be larger and last longer than previous mobile generations, with evolving new use cases for consumers, enterprises, and governments alike. We remain determined to reach our long-term target of EBITDA margin of 15% to 18% no later than 2 to 3 years, while we also establish Ericsson on a higher growth trajectory. I'm very proud to work with colleagues whose dedication and commitment have ensured that we can keep on delivering products to our customers despite global supply challenges. So a big thank you to all of my colleagues. Before starting with the Q&A, I would like to mention that we are planning for a Capital Markets Day on December 15, and we will come back with more details about the venue and our strategy, as well as the opportunities for growth that we see going forward. But now, over to you, Peter, for questions.

Thanks, Börje. I would like to call out Mark and inform the audience that we will start now the Q&A and how to proceed.

Thanks, Mark. And we’ll start with Francois Bouvignies from UBS. Hello, Francois.

So I have 2 quick questions if I may. So the first one is on inflation. It’s obviously one of the main highlights for this quarter. I wanted to know if it's possible to quantify the impact you saw this quarter. In the release, Börje, in your presentation, you said that as contracts expire, you're going to try to adjust pricing. My understanding is that the prices are mostly fixed until the end of the year. Should we expect this drag of inflation to continue until the end of the year? Or is there anything you can do before that? That’s my first question, and I have a quick follow-up.

I can take the latter part of that question. Well, the key for us to fight inflation and, as you know, the inflationary pressures have been very large on components as well as the supply chain: transportation, wages, etc. during the both first and second quarter. The key for us to combat inflationary pressures in the short term is actually by introducing product substitutions. We spoke about that in the first quarter, and that continues to be a key driver, allowing us to start discussions about prices of new features, while also lowering product costs. We remain very committed to that model, which has been with us since 2017, and we continue to see its benefits. Regarding contracts, they typically last from 1 to 4 years in this industry. They are regularly renewed, and as they are renewed, we can adjust terms. In the interim, we, of course, have the ability to adjust some service components and certain things, but our core approach to price adjustment remains through product substitution. We will continue to execute this strategy.

Maybe I can add when it comes to predicting this; it’s hard for these macro factors. What’s more important for us is to plan for this and to continue with the mitigation we’ve been doing. I want to emphasize that this is not something new; we have been working since 2017 with this strategy. We invest to innovate, launch new products to please customers, and price accordingly over time. So that’s really our big focus here. It’s better to plan for a continuation of this situation than to assume it will improve soon. As for inventory, we believe that inventory will decline towards the end of the year due to our supply and delivery planning.

We should also remember the gross margin impact from IPR. We will ensure we get the right deal rather than optimize just an individual quarter's performance. A key reason for the year-over-year drop in gross margin is about making sure we are not just trying to optimize for speed but are in it for the long run with the right agreements.

Yes, as a quick follow-up, Peter. You mentioned, Börje, in your presentation, the impressive market share on the 5G traffic outside China concerning the RAN side and 80% of the top 20 operators using your 5G Core, which shows you time to market and adding more advanced products as the 5G ramp continues. Moving forward, based on your deal win rate, do you see this market share as sustainable as the 5G market grows? Should we expect a normalization of this market share, or do you still see similar market share as we move into the next year based on your behavior?

If we look at the 5G Core, the key part that will help us improve performance is when traffic starts to pick up on the 5G networks. That's mostly system integration revenue today, and we have incurred some extra costs on initial deployments. So, in a way, it depends on how traffic picks up, etc. On the RAN side, yes, we have strengthened our market share from 33% to 39% over the past five years. Our ambition is to continue to gain some footprint moving forward because we believe long-term scale in this industry is critical.

Of course, we talk a lot about the RAN market. It’s about USD 41.5 billion to USD 43 billion, but we are focusing on more than just that. Our growth discussions regarding the 5G Core win rate are separate from the RAN market. New growth areas, such as the enterprise side and Cradlepoint business, are going on top of the RAN market. So when we talk about growth, it’s not limited to just the RAN market.

Thanks, Carl. And thanks, Francois, for those questions. We'll move to the next question from Alex Duval, Goldman Sachs.

You talked about a solid 5G backdrop this year and you've adopted a raised growth forecast for North America. I wondered if you could talk a little bit about how you're feeling about sustainability of RAN demand into next year. Given the discussion about challenging macro backdrop and the consumer's disposable income, how should we think about that? Secondly, on Digital Services, it seems you had solid organic growth, but there were initial deployment costs involved in starting 5G Core projects. Do you think these costs are going to persist? Will more profitable software revenues come through? Overall, it would be great to get a perspective on how you can get more margin leverage out of that business.

Yes, I can start with the first one. For the 5G market, we've seen that largely 4G has been focused on the consumer. And with 5G, we add new segments, so think about enterprises, as well as adding new segments like cloud gaming and XR, which will drive further traffic growth in the Networks. Over time, the growing traffic requires active components in the network, and that’s where we are. We believe that 5G, while potentially having a higher peak than earlier generations, will also last longer because it addresses so much more. Short-term fluctuations are hard to predict but history shows that telecom is more insulated from recession impacts compared to other sectors. And while CapEx might taper off, our market will keep growing, and that's why we remain confident.

Regarding Digital Services, customers are moving into 5G, which is about cloud technologies and intelligent automation. 5G Core plays a critical part in enabling the full potential of 5G networks. We are gaining contracts, even 80%, in this space. Implementation takes some initial costs, but as those networks go live, revenue will increase accordingly. We saw strong growth of the 5G Core contracts this quarter already, but there's much more to come, obviously.

Thanks, Carl and thanks, Alex. We will move to the next question from Peter Kurt Nielsen at ABG.

Just a question, Carl. If I can stay with Digital Services. You spoke extensively at Q1 about the need to improve sales execution. What we see this quarter is organic growth. Is this simply a function of the better market and the 5G Core market picking up, or have you seen early signs of your own execution improving here? Are you confident in this improvement going forward? To what degree do you expect the new structure and the merger with Managed Services to help you on that?

As we get further into these initial contracts, we learn, improve, and achieve milestones in the projects reflecting in growth. 16 out of the 20 largest operators have chosen Ericsson for 5G Core, and we are implementing those contracts. This will drive revenue and profitability in the coming periods. Regarding the new structure, there are clear benefits in merging Managed Services and Digital Services, leading to better sales execution. It’s easier to present a clear solution argument when we can offer an integrated orchestration and management solution.

Yes, regarding the Enterprise segment, it’s something we are focusing on heavily and believe will be a significant market in the near future. We're currently seeing predominantly growth in Cradlepoint. We're beginning to see growth in Dedicated Networks from a low starting point. We’ve received encouraging feedback from customers about our competitive solution. We still need to strengthen our go-to-market strategy, which is why the formation of the Enterprise Wireless Solutions business area is so important. This will help drive growth for dedicated networks in the future, with the target to start contributing by next year.

Thanks, Börje. We’ll move to the next question from Stefan Slowinski at BNP Paribas.

Two quick ones. Just on the supply chain side. It sounds like you have managed that well in terms of getting the actual supply even if you're seeing inflation. Can you confirm that you didn't have any negative impact on revenues in terms of being able to secure the supply that you needed? My second question is just on the higher costs you're seeing. I understand you want to push through some of those component inflation costs over time. It sounds like you're also incurring more costs due to moving away from just-in-time delivery to more warehousing costs. How much of these costs will be permanent, and will it impact your longer-term margin potential as you slightly change the model?

No, we haven't seen any material revenue impact. Our supply teams and the organization have handled the delivery situation well, delivering to customers on time and in the required quantities. When looking at the long-term perspective, we are planning for a resilient supply chain, even if it means costs won't be as low as pre-pandemic. If the situation eases, fine, but we prefer to be agile. Our priority is to ensure customer deliveries.

I think this will be a trend across many industries. The supply chain previously optimized for costs will now see higher costs due to resetting global supply chains amid geopolitical uncertainty. We believe we can offset that with product substitutions, continuing to focus on innovation and driving new cost-effective solutions. Over time, we’ll manage fluctuations. Our ongoing strategy will enable us to execute effectively.

Thanks, Stefan. Next question from Daniel Djurberg at Handelsbanken.

My first question would be a little bit on the cost side. You mentioned the enterprise opportunity and fixed value success versus one network level, which might prolong the 5G cycle. Given the inflationary times, will you need to address your underlying OpEx base to secure your long-term margins before we see these segments really taking off? Regarding the R&D hike you mentioned on silicon and Cloud RAN, should we think of these investments as temporary or more like a new baseline?

I believe we will see an increase in expectations from outside analysts. We have a journey where many have been behind the 5G takeoff, and I expect that to continue. We’re underestimating the new applications, and while they may not come today, they will require densification of the 5G network going forward. Thus, we believe CapEx will increase in coming years, and we are committed to invest in this space.

As we get further into this initial deployment phase, we learn how to improve execution and learn project milestones reflected in growth. The 16 out of 20 largest operators selecting Ericsson for 5G Core indicate the importance of that delivery. The merger of Managed Services and Digital Services will lead to cost synergies and improvements in sales execution.

Thanks, Daniel. We'll move to the next question.

Just a couple more on inflation and component cost inflation. You’ve spoken about the introduction of stronger products and how it could be helpful to offset cost inflation. Do you think operators will accept this introduction of services faster than in the past? Is it feasible that they are willing to pay for that, or is that more of a given considering that much is driven by software? Secondly, regarding cash flow, you stated inventory will reduce later in the year. Why not leverage the strong cash position to build more inventory now rather than later when costs are expected to rise?

In optimizing inventory levels, our priority is ensuring customer delivery. We’re securing components for customers, which has led to elevated inventory levels. Delivering on time and securing the needed components outweighs short-term component costs. We are entering into longer-term contracts to secure allocations from suppliers as well.

This industry traditionally has a deflationary element due to the exponential growth of traffic. As we introduce product substitutions, we can discuss new pricing based on the value delivered. A faster cadence of product introductions will support pricing discussions and lower overall product costs. Software’s increasing share of the business will also decrease inflationary pressure because as software grows, it is less impacted by the inflation seen in hardware. We have been executing on this strategy since 2017, so the improvements in gross margin stem from this approach. Now, with cost inflation, we need to enhance the cadence of new product introductions to continue our successful execution of this strategy.

Sorry, I think it's significant to talk about IPR revenues. They are accruing, but it's hard for participants to follow. Can you quickly describe your confidence in that process?

Start with the value of our 5G patent portfolio, and third-party analysts recognize we have a very strong position there regarding standard essential patents which we have invested heavily in. We're working on ensuring we capture that value through negotiations and litigation. We believe we're well-positioned to achieve positive outcomes, but we will take our time to ensure we get the right agreements. We are confident that these revenues will come back as we conclude negotiations and renewals.

Thanks, Börje. That was the last question. Before closing the call, is there any last remark from your side, Börje?

Thanks, Peter, and thank you everyone for participating and for all the questions. It's another quarter where we have shown that we execute on our strategy to be a leader in the mobile infrastructure business and also start to build a focused presence in the enterprise market. We were able to grow the company by delivering to customers, achieving a growth of 5%. Our strategy of product substitutions has also been effective in managing operational costs. We are currently at an EBITDA margin of 14% on a rolling 12 months basis, getting close to our long-term target of 15% to 18%. We remain committed to achieve those targets within the next 2 to 3 years while establishing a higher growth trajectory for Ericsson. Our technology has broad applicability, and I'm excited about the future. Thank you all, and I wish you a good summer.

Thank you.