The Ericsson Set
Bear Argument
By
Chris Rugaber (TMF RFK)
The bulk of the bear case for Ericsson is fairly predictable, but that doesn't make it any less valid. The Swedish mobile infrastructure and handset manufacturer is losing money hand-over-fist in its cell phone division, and while the company's handsets only account for about 20% of its business, gross mismanagement in that unit has pummeled the company's shares.
In addition, while Ericsson is winning most of the contracts to construct third-generation (3G) wireless data networks that have been announced so far, this does not necessarily guarantee a steady cash flow for the company. Wireless carriers are demanding generous payment terms, and Ericsson hasn't exactly demonstrated top-notch operational efficiency, at least in its handset business. Certainly, there's no question Ericsson has a great market opportunity. But will it be able to capitalize on it profitably?
The mobile phone mess
Ericsson shareholders are painfully aware of the company's shortcomings in its mobile handset business. Margins and earnings deteriorated dramatically this year, culminating with the third-quarter report on October 20. While sales and earnings grew strongly in the Network Operating division, the Consumer Products unit -- which is essentially mobile phones -- lost more than $400 million, about 50% more than the previous quarter, on $1.41 billion in sales. As a result, overall operating margins dropped from 11% in previous quarters, to around 7%. The company expects to lose almost $1 billion on mobile phones in the fourth quarter, bringing losses this year in the division to more than $1.5 billion.
Ericsson's share of the mobile phone market almost surely dropped in the third quarter. The company held 10.3% market share at the end of the second quarter, while Rule Maker Nokia <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NOK)") else Response.Write("(NYSE: NOK)") end if %> controlled 27.5% and Motorola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MOT)") else Response.Write("(NYSE: MOT)") end if %> had 15.6%. Management continues to blame component shortages and an ongoing restructuring for the company's mobile phone troubles, as well as a "weakening replacement market" in Europe.
The real problems lie with the company's business strategy and manufacturing execution, however. While Nokia is ruthlessly sacrificing some of its ample operating margin to increase market share, and is introducing additional handheld devices that appeal to new and current mobile phone users, Ericsson continues to flounder through its "back to profitability" restructuring plan.
The restructuring, announced in July, involves outsourcing more of the company's manufacturing and shifting additional production to cheaper locales, while retraining thousands of workers to make infrastructure equipment, rather than mobile phones. While it's still early, there's no sign of any benefit from the plan so far, and the company does not expect mobile phones to return to profitability until the middle of next year.
Meanwhile, a Swedish newspaper reported last week that the company scraps 25% of its mobile phone production, with the percentage of sellable phones sometimes dropping to as low as 60%. This is an amazing number, if true, and compares to Nokia's and Motorola's targets of 90-95% sellable phones.
Of course, there's plenty of speculation that the company might drop its mobile phone business, but there is no sign of that from President Kurt Hellstrom, who continues to maintain that the company needs to offer "end-to-end" solutions. Ericsson seems to believe that mobile phones are a necessary part of the wireless infrastructure services it provides. The company may also feel it needs to maintain its handset business to ensure a role in the development of future wireless standards and protocols. Regardless, as long as the company keeps its struggling mobile phone business, its leadership in wireless infrastructure equipment will be overshadowed and its stock will probably flounder.
3G is not a guarantee
Speaking of the infrastructure business, I am sure my worthy opponent has already waxed eloquently about it: leading market share, 17 of the 22 3G contracts signed so far, and so on. If he skips it for some reason, let me acknowledge that, as European wireless carriers upgrade their networks for high-speed data capability -- a process that will cost billions -- Ericsson will certainly benefit.
Nevertheless, it may not turn into the unmitigated manna from heaven that many expect. To begin with, Ericsson faces plenty of competition from Nokia, Alcatel, Nortel Networks <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NT)") else Response.Write("(NYSE: NT)") end if %>, and others. As a result, while the company may have a piece of those 17 of 22 contracts, it doesn't always have all or even most of the business. Investors should be sure to look beyond the press releases for the full picture. For example, while Ericsson recently won a $250 million 3G contract from Spain's Xfera, Nortel got the larger chunk in its $935 million agreement.
In addition, European wireless providers, burdened with the billions of euros they've laid out for next-generation wireless licenses, are demanding very generous payment terms from network vendors. For example, when Orange PLC, Europe's second-largest mobile phone company and a subsidiary of France Telecom <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FTE)") else Response.Write("(NYSE: FTE)") end if %>, awarded multibillion-dollar contracts to Alcatel <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ALA)") else Response.Write("(NYSE: ALA)") end if %>, Nokia, and Ericsson, France Telecom Director Didier Quillot noted that "All three suppliers offered very significant financing credits," meaning that much of the work and equipment will be provided before payment.
This was especially apparent in the highly anticipated $1.35 billion contract that Germany's MobilCom announced on October 20. According to press reports, Ericsson signed on to provide wireless infrastructure equipment, handsets, and consulting services worth 2.4 billion euros, in order to receive 1.6 billion euros in 2003. I'm not sure how the math works on that, which may be why reports surfaced a week later that Ericsson only signed a letter of intent, not an actual contract, and that the financing details may still be up in the air.
Regardless of the details, it seems clear where the balance of power lies. Some carriers are adding penalties as well, since they want the networks to be built as rapidly as possible. MobilCom CEO Gerhard Schmid mentioned this in a Bloomberg report: "We've set up the time frame in such a way that nobody else will be able to finish their networks faster. The penalties are so heavy that if the work isn't done in a certain time period, we won't pay for what's been delivered."
Well, Ericsson investors better hope that the company can snap to it and please its MobilCom masters -- if there really is a contact -- and that a company which has to scrap a quarter of its mobile phone production can perform in a more disciplined way with its infrastructure equipment.
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