Analyst Note | by Mark Cash Updated Oct 22, 2020

For the third quarter, no-moat Ericsson's adjusted EPS of SEK 1.77 blew
away CapIQ consensus expectations of SEK 1.38, while 1% year-over-
year revenue growth was in line with CapIQ consensus projections.
Adjusted gross margin increased 550 basis points year over year to
43.2% as the networks and digital services businesses posted a higher
percentage of software sales in the quarter. Previous investments in
developing a competitive 5G product portfolio are also starting to fuel
gross margin expansion as Ericsson gains scale. The company
established positive margin for 5G contracts in the price sensitive
Chinese market in the quarter, which is a critical geography for creating
a large footprint. The strong results led management to reaffirm its goal
of surpassing 10% adjusted operating margin for the year, up from 4%
in 2019. We are hesitant about longer-term revenue growth prospects
in the radio network equipment, or RAN, market; however, we believe
Ericsson is strongly executing to win critical 5G contracts and can find
new growth opportunities in enterprise wireless networks and
software. With more confidence in an improving operating profile, we
are increasing our fair value estimate to SEK 101 from SEK 97 and
believe shares are fairly valued.

Compared with prior-year sales, networks grew by 6%, digital services

declined by 12%, managed services shrank by 14%, and emerging
businesses declined by 3%. Sales growth was spurred by strong 5G
demand in China, U.S., Australia, and Indonesia; contrasted with the
prior year, Northeast Asia was up 39%, Southeast Asia up 5% year over
year, and North America was down 3% year over year. For 5G, Ericsson
now has 112 commercial contract agreements, is live in 65 networks,
and stated the majority of market share gains are against non-Chinese
competitors. Using Dell'Oro as a source, Ericsson expects the RAN
equipment market to grow by 8% in 2020, with China up 33%, but for
the RAN market to have a flat CAGR between 2019-24.

Business Strategy and Outlook | by Mark Cash Updated Apr 10, 2020
Ericsson is a leading provider of hardware, software, and services to
communication service providers. The company is off to a good start in
5G as carriers look to expand their network capabilities in the 2020s. 5G
may have a longer spending period than previous wireless iterations,
and we believe Ericsson's robust portfolio of hardware and software
coupled with its industry leading services business has it primed to take
advantage of 5G network demand.

The company has been on a turnaround mission after its 2015 apex. We
believe that Ericsson is making wise strategic efforts and we applaud
management's prudent outlook after slashing its cost of goods and
operating expenses while committing to exit or renegotiate unfavorable
contracts. We believe the management team has properly focused the
company on invigorating networking innovation while honing
operational efficiency.

That said, we do not believe the CSP equipment provider industry lends
itself to economic moats because CSPs multisource vendors and flex
pricing power by pitting suppliers against each other. However, we
expect Ericsson's restructuring and strategic efforts, combined with 5G
demand, to create top-line and operating margin expansion. We believe
that Ericsson's efforts within software-defined networking will be
fruitful as software becomes essential in a 5G world. Our expectation is
for Ericsson to gain from 5G networks requiring many small-cell
antenna sites to propagate the fastest transmission bands. Ericsson
should profit from 5G networks creating more product use cases such
as "Internet of Things" devices within cars and factories. Based on our
view that network complexity will increase as firms control and
monitor a rapidly growing quantity of Internet of Things devices, our
expectation is for Ericsson's software and services to be in high
demand. The company also creates revenue from licensing patents that
are essential in the production of 5G smartphones (as well as previous
generations). We believe Ericsson may find licensing opportunities in
nonhandset markets, and that licensing revenue will help bolster
operating results.

Economic Moat | by Mark Cash Updated Apr 10, 2020

We assign Ericsson with a no-moat rating and do not foresee the firm
generating sustainable excess economic returns in the future. While we
believe that Ericsson is one of the main benefactors of 5G infrastructure
spending by communication service providers, or CSPs, our
fundamental concern is the company's long-term ability to grow
profitably against formidable competitors. Strategic shifts and cost
reduction measures were necessary steps to facilitate Ericsson's
ambitious turnaround plan.

Ericsson's operating business groups include networks, digital services,

managed services, and emerging businesses and other. In 2019,
network products and services for CSP infrastructure represented 68%
of total revenue and generated had operating margin of 16%. The
digital services segment was 18% of 2019 revenue, with a 10%
operating loss, while managed services was 11% of 2019 revenue and
had a 9% operating margin.
The networks business provides hardware, software, and service
solutions for CSP cell networks. CSPs typically multisource their
hardware and exert pricing power over network equipment providers
since a small quantity of suppliers vie for a limited number of contracts.
The equipment providers aggressively price hardware and attempt to
profit over the life of CSP contracts through services and manufacturing
cost outs. Ericsson, Huawei, and Nokia dominate the equipment
provider market and benefit from being trusted hardware incumbents
and technology leaders. ZTE and Samsung are formidable foes that are
making the marketplace more cost competitive. Although we believe
that Ericsson stands to benefit from CSPs building out 5G networks, the
company also faces challenges as 4G networks become commonplace
within highly cost sensitive geographies. The potential of 5G's speed is
limited by its short distance range and interference susceptibility.
Ericsson should benefit from 5G network infrastructure requiring small
cell sites, but we expect limited upside as CSPs retain their
multisourcing tactics.

Ericsson's digital services group, containing products and services for

operating and controlling a network, was restructured to focus on
products and software over services. The company is reviewing its
contracts with a focus on profitability over top-line growth. As Ericsson
reviewed and exited some contracts the segment revenue has
contracted, and company management believes positive non-IFRS
operating margin for the segment is achievable by 2020. We believe the
segment's focus on 5G and cloud-based products should drive more
value for CSPs and potentially create solutions for enterprises that will
utilize Internet of Things devices on their networks. The managed
services business, which operates and optimizes customer networks, is
turning around its operations through contract reviews and automation
investments. In our view, neither operating segment contains
sustainable competitive advantages; nonetheless, increased network
complexities due to 5G and Internet of Things networks could create
demand for Ericsson's expertise and services.

An important revenue stream for Ericsson, and other CSP equipment

vendors, are license fees that stem from patents developed while
innovating communication protocols and technologies. For 5G NR,
Ericsson's stated license fee is $5.00 per device or as low as $2.50 in
lower average selling price handset markets (on an individual case
basis). As a comparison, Nokia announced a maximum EUR 3.00 ($3.46
as of the Aug. 21, 2018 announcement date) fee per device with 5G NR
capability and Qualcomm's rates are 2.275%-3.25% of the equipment
price depending on the device type. Even though Ericsson will benefit
from license fees, we do not see this as a competitive advantage over its
largest competitors or a method to guarantee excess returns on
invested capital.

Fair Value and Profit Drivers | by Mark Cash Updated Oct 21, 2020
We are raising our fair value estimate to $11.60 per share from $10.70
as a result of a better growth and margin profile alongside the effects of
foreign exchange rates. This fair value estimate represents a fiscal 2020
enterprise value/adjusted EBITDA of 10 times.

We expect Ericsson to earn 2% revenue growth in 2020 and generate a

five-year revenue CAGR of 2%, which is mainly driven by CSP 5G
network build outs and additional 4G capacity demand. Additional
revenue is expected from 5G networking solutions being used across a
wider array of industries deploying Internet of Things devices.

In our view, Ericsson's operating margins will expand into the double
digits by 2020 for a couple of reasons. We expect gross margins to
expand into the low-40% range, up from 23% in 2017 and 37% in 2019,
through product costs reductions and selling more software. We expect
Ericsson to benefit from selling services to help simplify and manage
complex networks as more Internet of Things devices touch 5G
networks. Licensing revenue from 5G handset sales should increase
Ericsson's margin profile. Additionally, management's focus on
decreasing SG&A costs by making a more simplified organization should
create operating margin leverage.

Ericsson reports its financial results in Swedish krona, and we use an

exchange rate of SEK 8.74 per $1 as of Oct. 21 to derive our ADR fair
value. There is a 1/1 ADR ratio to the local shares.

Risk and Uncertainty | by Mark Cash Updated Apr 10, 2020

We assess that Ericsson's fair value estimate has a high uncertainty
rating. Our expectation is for a competitive market with Huawei, Nokia,
ZTE, Samsung, and Cisco vying for a limited number of important CSP
contracts. CSP pricing requests could be unsustainable and may test
Ericsson's fortitude of only engaging in value creating deals. Ericsson's
turnaround efforts require considerable operational efficiency
improvements that may not be established in a highly competitive
marketplace. Higher margin items like software from Ericsson could be
scorned for solutions from lower cost or pure-play software vendors.
We note that price sensitive economies could drag down Ericsson's
revenue and margin profile if the company cannot extract
manufacturing and process efficiencies.
Ericsson's turnaround story coincides with 5G infrastructure build outs.
If the promise of 5G's speed and capacity do not materialize or if 5G is
too expensive to justify its benefits, then enterprises and consumers
may forgo the new wireless generation. Growth expectations could be
dragged down if Internet of Things devices do not expand at a
significant rate or if networks do not require services faster than 4G.
These potential risks would make Ericsson's 5G solutions limited in
scope and the company could face turbulent headwinds.

An additional uncertainty are possible government restrictions on the

usage of certain CSP equipment providers. In 2018, the United States
and Australia banned its CSPs from using China-based Huawei and ZTE
equipment in their network buildouts for 5G. A risk exists that the U.S.
and Australia ban could be repealed, thus allowing greater competition
from Huawei and ZTE in these regions. Similarly, China could favor
domestic brands over Ericsson or influence other nations to use Huawei
and ZTE over other vendors.

Stewardship | by Mark Cash Updated Jul 17, 2020

We give a Standard stewardship of capital rating to Ericsson. In our
view, the January 2017 appointment of Börje Ekholm as president and
CEO spurred a company turnaround. Ericsson's entire executive team
has been renewed since Ekholm's tenure as CEO, and half of the board
members were elected since 2017. Although there are many new faces
in important roles, we believe the team is doing a commendable job at
this juncture. Ekholm, an Ericsson board member since 2006, has
provided a focused rejuvenation plan while being forthright about the
company's past issues regarding overextending its ventures and
participating in unprofitable contracts. We believe the management
team has done a commendable job in leading Ericsson through the
repercussions that came from infractions of the United States Foreign
Corrupt Practices Act that occurred before Ekholm took the helm. To
focus on the core networks business, since 2017, Ericsson has
jettisoned its power modules business, Montreal ICT data center,
Swedish field services business, and sold 51% of its media solutions
division.

Ericsson's two largest shareholders Investor AB and AB Industrivärden

control 23% and 15%, respectively, of the total voting power of the
company at the end of 2019. These large portions of voting control have
been predominantly constant over the past few years, and we do note a
level of risk inherit with concentrated ownership prioritizing its own
needs before all shareholders.
The company pays a yearly dividend that was slashed for the recent
turnaround efforts. We expect a gradual increase in Ericsson's dividend
to be the primary source of returning capital to shareholders. As the
firm takes a more judicious approach to capital deployment, we expect
R&D for the core networks business to be the primary benefactor of
investments. Ericsson completed the acquisition of Kathrein's antenna
and filter business in 2019 to bolster its core offerings, and we believe
this matched the company's growth strategy. In our view, Ericsson will
focus on networking innovation and a streamlined cost structure to
reward shareholders through earnings growth.