3 Reasons Ericsson Investors Are in Trouble

Wireless is a growth industry, right? If that's the case, someone forgot to tell Ericsson.

Mar 15, 2014 at 12:30PM

Everyone knows that the wireless business is a growth opportunity for many companies. Just like the sellers of picks and shovels to gold miners in the gold rush, network equipment companies might be a great way to play this expansion. However, it seems someone forgot to tell Ericsson (NASDAQ:ERIC).

No shortage of competition, and Ericsson is struggling
In the networking field, Ericsson competes with companies like Alcatel-Lucent (NYSE:ALU) and Juniper Networks (NYSE:JNPR). This brings us to the first reason Ericsson investors are in trouble. Compared to Alcatel-Lucent and Juniper, Ericsson is not doing well at all.

Of the three companies, Juniper Networks is the clear growth leader. The company reported that overall revenue increased by 12%. Juniper's platform systems routing business is its largest division and reported that sales increased by 17%. By comparison, Alcatel-Lucent reported overall sales were flat, but the company's largest division, its access business, grew revenue by 15%.

Ericsson also reported flat sales overall, but the company's two largest divisions both registered a decline in sales. In the networks business, sales declined by 1%, and the global services business saw sales dip by 3%. What is even more troubling is, without a licensing agreement with Samsung, Ericsson's results would have been even worse.

Getting worse, not better
The second reason Ericsson's investors are in trouble is, the company's two largest divisions are in a state of decline that is getting progressively worse.

The networks division represents about 52% of Ericsson's total sales, and in five of the last eight quarters, sales have declined. The global services business makes up just over 40% of revenue. From the beginning of 2013 to the current quarter, sales growth decelerated from 26% growth to a decline of 3%.

When more than 90% of a company's business shows weakness that is getting worse, investors should probably stay away.

Hidden in the margins
One of the ways to evaluate companies in the same field is by looking at their operating margin. In theory, a company with a strong operating margin has either pricing power, more efficient operations, or both.

On the surface, it appears that Juniper has the best operating margin of the group at 15%. If you don't dig beyond the headlines, Ericsson comes in second at 13.5%, and Alcatel-Lucent finishes last at 8%.

However, if we look at what is behind Ericsson's operating margin, we see that a licensing agreement with Samsung is the main reason the company looks as good as it does. The Samsung Agreement (as the company refers to it) essentially ends the legal dispute between the two companies worldwide. This agreement means that Samsung will make initial payments, plus subsequent royalty payments in the future.

If we exclude the Samsung payments, Ericsson's actual operating margin would have been closer to 8%-9%, as opposed to the reported 13.5%. This agreement increased the company's networks operating margin by 8% and the smaller support solutions margin by 21%.

The problem, of course, is many agreements are set up so the initial payment is larger than ongoing royalties. Alcatel-Lucent has been restructuring and dealing with debt issues. The fact that Ericsson was barely able to match Alcatel-Lucent's operating margin is the third reason investors are in trouble.

A bumpy ride
Ericsson should be in a position to benefit from continued growth in the wireless business, yet more than 90% of its revenue is declining. When you combine this problem with margins that may not be sustainable, investors may be in for a bumpy ride.

While Ericsson is proposing a dividend that would equate to a yield of more than 3.5%, the company has the slowest expected growth rate of the three companies we've looked at. Growth investors should consider substituting Ericsson for Alcatel-Lucent. The latter is expected to grow EPS by 80% or more for the next five years. Ericsson is expected to post 8% growth by the same measure. Alcatel-Lucent's expected growth is believable as well, with the company's recent wins with Verizon and China Mobile as significant revenue drivers.

If you are looking for growth and income, Juniper offers a newly minted yield of 1.5% that is 2% less than Ericsson, but the company's EPS growth is expected to outpace Ericsson by 5% per annum in the next few years. With similar forward P/E ratios, Juniper looks like the better deal.

No matter how you look at it, there seem to be better opportunities than Ericsson. The stock trades for about what it did a year ago, and the future looks no brighter today.

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Chad Henage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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