Ericsson (ERIC) Q2 Earnings Miss, Outlook Grim, Shares Down

In its second-quarter 2017 results, Ericsson (BS:ERICAs) (NASDAQ:ERIC) reported non-IFRS earnings of SEK 0.17 (2 cents) per share (excluding amortizations, write-downs of acquired intangible assets and restructuring charges). This is down from earnings of SEK 0.83 recorded in the comparable quarter last year. Declining sales and shrinking gross margins put immense pressure on the bottom line.

The figure also compared unfavorably with the Zacks Consensus Estimate of earnings of 5 cents, marking the sixth consecutive earnings miss for the Swedish communication technology and services giant.

Investors sent the stock tumbling 10.7% at one point in pre-market trading, as the company cautioned that fragile market conditions and shrinking telecoms equipment market could hit its profits by as much as $600 million over the next year. Ericsson also warned that getting the beleaguered company back on the profitability track would call for even steeper cost cuts.

Contracting product demand, lower software sales and weak IT & Cloud business results pushed the company’s earnings into the red, as the Swedish firm reported a net loss of SEK 1 billion ($113.5 million) in stark contrast to net income of SEK 1.6 billion recorded a year ago. A steep decline in revenues over the past few quarters made things worse for Ericsson.

Inside the Headlines

Net sales for the quarter fell 8% year over year to SEK 49.9 billion ($5.7 billion). The top line also missed the Zacks Consensus Estimate of $5.8 billion. Weak mobile broadband market, declining network sales and lower investments in parts of Europe, Latin America and the Middle East & Africa dragged down revenues.

The decline in sales was all-pervasive, with all three operating segments of the company charting decline in revenues. Lower IPR licensing revenues, in particular, were a major drag on second-quarter sales.

Ericsson Price, Consensus and EPS Surprise

Segmental Performance

As part of its recently announced restructuring plans, Ericsson has reorganized its operations to focus on three core areas – Networks, Digital Services and the Internet of Things. The three segments that comprise the company’s reporting structure are: Networks, IT & Cloud and Media.

On a segmental basis, Networks revenues were down 8% year over year to SEK 36.8 billion ($4.2 billion). Persistent low investments in mobile broadband in certain markets and lower managed services sales resulted in the poor performance of this segment.

IT & Cloud revenues fell 5% year over year to SEK 10.9 billion ($1.2 billion). Lower legacy product sales hampered the segmental performance and services performance also displayed weak numbers.

Media revenues fell 6% year over year to SEK 2.2 billion ($249.7 million), primarily due to lower sales of legacy products.

Ericsson’s gross margin (excluding restructuring charges) in the quarter contracted 340 basis points year over year to 29.8%. A bigger share of lower margin business, along with poor IPR licensing revenues, resulted in the margin contraction.

The decline in Ericsson’s operating margin (excluding restructuring charges) was even more pronounced – it went down 2600 from 5.1% in the prior-year quarter to a negative 2.5%. The impact of lower gross margin trickled down to operating margins, while higher operating expenses further hurt the operating margin.

Restructuring Plan

Late in March, Ericsson’s new CEO, Börje Ekholm announced a restructuring plan to cut costs and streamline the company’s focus areas, as well as explore options for the media business. Per the restructuring, Ericsson expects to take provisions, write-downs and restructuring charges this year, with most of them already booked in first-quarter 2017.

In the current quarterly report, Ekholm warned that an uncertain market could wipe out as much as SEK 5 billion ($600 million) of operating income over the next year. There is also an increased risk of market and customer project adjustments, which can have a negative impact of SEK 3-5 billion on the operating income in the coming 12 months.

Ericsson plans to accelerate its planned cost cuts and scale back expansion plans that aren’t moving as anticipated, and refocus on the company’s core business of selling networking equipment prior to the expected roll-out of 5G networks.

The company has identified 42 service contracts that it will exit, renegotiate or transform — a process which will help boost profits. Broadly, the company plans to invest in research and development to fortify Networks business and intends to stabilize IT & Cloud roadmaps.

Restructuring charges for 2017 are anticipated to come in the higher end of the previously announced range of SEK 6–8 billion.

Liquidity

During the quarter, cash flow generated from operating activities set off the cash flow used in operating activities. Ericsson’s cash and cash equivalents as of Jun 30, 2017, came in at SEK 21.4 billion ($2.5 billion) compared with SEK 28.9 billion a year back.

To Conclude

Ericsson expects a “high single-digit percentage” drop in the market for radio access networks this year, which is worse than previously expected. Overall, the company expects the industry trends and business mix in mobile broadband to prevail this year as well. Europe and Latin America — the markets with the biggest impact — are likely to have an increasingly challenging investment environment.

Nevertheless, Ericsson still expects to stabilize its operations amid a difficult market next year and remains hopeful of reaching its targeted operating margin of 12% beyond 2018. Ekholm’s restructuring plan will help streamline Ericsson’s focus areas, improve profitability, and revitalize its technology and market leadership. The company also plans to explore options for its media business and review “low-performing” contracts in its managed service business.

Whether these steps will allow Ericsson to jump back on the growth track remains to be seen. However, as of now, we have a Zacks Rank #3 (Hold) on the stock, as we are apprehensive over the effect of the restructuring and tough market conditions on the company’s profits and share price in the near term.

Stocks to Consider

Some better-ranked stocks in the broader sector include Exa Corporation (NASDAQ:EXA) , Microsoft Corporation (NASDAQ:MSFT) and Red Hat, Inc. (NYSE:RHT) , each sporting a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Exa Corporation has an impressive average positive earnings surprise of 91.7% for the trailing four quarters, having beaten estimates strongly all through.

Microsoft has a striking earnings surprise history for the last four quarters, having beaten estimates all through, for an impressive average beat of 10.4%.

Red Hat has a robust earnings surprise history, with an average positive surprise of 11.1%, driven by consecutive earnings beats over the trailing four quarters.

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SEK1 = $0.1135 (Period average from Apr 1, 2017 to Jun 30, 2017)

SEK1 = $0.1183 (as at Jun 30, 2017)