My investment thesis for Telefonaktiebolaget LM Ericsson (NASDAQ:ERIC), or simply Ericsson, the Swedish telecom company, is bearish. Given its uneven performance, the company is in a kind of “limbo,” not fitting into the growth, value, or income categories of stocks.
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Ericsson’s trading performance has been highly volatile this year, despite an overall increase of around 21% over the past twelve months. The stock plummeted by approximately 22% from January to April, but then rallied strongly after reporting Q1 results that pleased the market.
The positive market reaction was likely driven by growth in gross margins. However, considering the significant headwinds the company has faced and is likely to continue facing, these gains may be fully priced in and offer limited appeal.
As the company faces tough comps, headwinds from the slowdown in telecom carriers’ CapEx are expected to persist throughout the year. Ericsson’s results will largely depend on cost control and its ability to close deals, which raises risks related to execution.
Read on to see the five reasons why I am bearish on ERIC.
ERIC’s Tough Comps on 5G
Ericsson is a major global player in the telecommunications sector, specializing in technology and services for telecom carriers. The company is heavily invested in network infrastructure, enterprise solutions like IoT (Internet of Things) and cloud services, and the advancement of 5G technology.
With telecom operators accelerating investments in 5G networks, especially from 2020 to 2021, Ericsson has reaped significant benefits. These gains were supported by projections that global operators would invest approximately $1.1 trillion in capital expenditures (CapEx) by 2025, with about 80% allocated to 5G networks.
In 2020, Ericsson’s shares surged, reflecting this trend, with its stock price rising about 100% from March 2020 to April 2021. From 2019 to 2022, Ericsson’s total revenues increased from SEK 227.22 billion to SEK 271.55 billion, a growth of approximately 19.5%.
However, the current landscape presents challenges. Over the past year, the company’s network sales, which account for 65% of its revenues, declined by 11% to SEK 171.4 billion, largely driven by a 46% drop in sales in the North America region. This reduction stemmed from tough comps as telecom operators reduced CapEx following peak investments in 2020 and 2022.
These factors have contributed to a 3% decline in group net sales in 2023, totaling SEK 263.4 billion. Reduced network sales have also affected the bottom line, with gross income decreasing last year to SEK 101.6 billion from SEK 113.3 billion in 2022. This resulted in a gross margin of 38.6% in 2023, down from an average of 40% over the past five years.
The good news is that management expects margins to improve to 42-44% in Q2, which could provide some relief. But, it’s important to note that this improvement is due to cost control measures rather than strong demand.
Continued Headwinds in 2024
In addition to an 18% decline in U.S. sales in Q1 2024, Ericsson experienced substantial drops in other regions. Southeast Asia, Oceania, and India, and North Asia saw sales fall by 38% and 22%, respectively. The entire mobile networks markets has been seeing reduced activity, and Ericsson is no exception.
As the management has put it in early this year, these trends are expected to persist throughout 2024, posing significant challenges. The strategy involves cost adjustments, although usually unpopular, to align with reduced revenue growth prospects.
“As we look ahead, 2024 will be a difficult year, and market conditions will prevail. And so, we currently expect the current market outside of China to further decline as our customers remain cautious and the investment pace normalizes in India.”
Ericsson’s CEO Börje Ekholm
To complete the somber picture, Ericsson has struggled to meet market revenue expectations in the last couple of quarters. This suggests a disconnect between its sales performance and what the market has been anticipating.
Dividend’s Safety Questioned
Furthermore, the company’s dividend seems shaky. Ericsson appeals to income-focused investors with a forward dividend yield of 4.1%, nearly matching the 10-year U.S. treasury yield of 4.3%.
However, concerns arise from the fact that last year. The Swedish company generated SEK 7.18 billion in cash from operations but distributed SEK 8.9 billion, indicating weak support. This is compounded by the volatility in cash flows, which does not align with the characteristics of a stable income stock.
Despite an improvement in Q1 2024, with SEK 5.07 billion in cash from operations compared to a SEK 5.8 billion loss in Q1 2023, CEO Börje Ekholm has ruled out capital deployment to bolster company shares. Repurchases are not on the agenda, as Ekholm emphasizes maintaining a strong and flexible balance sheet throughout the year.
Valuations Reflect Challenges Ahead
An additional concern is ERIC’s valuation. Ericsson trades at a forward P/E multiple of 17.48x, nearly 40% below the industry average but still above its historical average.
This initially attainable valuation reflects the significant challenges the company faces in sustaining growth, with projected top-line revenue expected to decline by 6.2% for the full year 2024. The reliance on closing major deals, such as the recent one with AT&T (NYSE:T), further complicates predicting the company’s bottom-line performance.
Comparatively, when placed alongside its domestic competitor, Nokia (NYSE:NOK), Ericsson’s premium valuation appears questionable. Nokia trades at a forward P/E of 9.5x, which highlights a notable valuation gap compared to Ericsson.
Wall Street Is Bearish on Ericsson
According to Wall Street consensus, Ericsson currently holds a Moderate Sell stance. Among the four analysts covering the stock, two recommend selling, while the other two suggest a neutral position.
The analysts’ average price target stands at $4.59, indicating a substantial downside potential of 25.6%.
Recently, Nordea Markets analyst Felix Henriksson became the final bull to change his stance, downgrading ERIC from Buy to Hold. With Q2 earnings expected on July 12, Henriksson views Ericsson’s long-term EBIDTA margin target of 15-18% (currently at 9%) with skepticism. He noted that the company’s shares need a “breather” after jumping 32% following the Q1 earnings results from mid-April to early June.
Conclusion
I find little reason for optimism regarding Ericsson’s current business situation. The company has been struggling with significant headwinds, expecting continued sales declines and relying on cost-cutting measures for a turnaround.
The dividend yield, while appealing, may not be sustainable at the current pace. Ericsson’s valuation doesn’t seem particularly low after its recent rally since Q1, as it trades at a considerable premium compared to Nokia.
Aligned with Wall Street’s pessimistic view on ERIC, I take a bearish stance on the company. I don’t see many chances for Ericsson to shine in terms of value or growth, or as an income stock.
