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3 Reasons Ericsson Investors Are in Trouble

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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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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 21, 2014, at 1:07 PM, NK123456 wrote:

    This is very good analysis but couple of other things to consider.

    Ericsson should viewed as an eco system, has a very large service & consultation division. Where as JNPR/ALU/CSCO are mostly device vendors.

    Ericsson is Google of networking world with products & services in all the area's (Radio, access, edge, core, subscribers etc etc too many to list), there is no other company with this kind of business structure (though huawei is trying to replicate it), and they are one of the biggest network equipment vendor since 1848.

    Do you know they collect royalty from every handset sold anywhere in world. Their GSM patent portfolio itself is worth 40 billion dollars and growing.

    If we look into decline on network sales, its mostly limited to older product lines (Microwave, 1G etc where technology is obsolete) & this is expected.

    One big difference between Ericsson & JNPR is in size & repetition of business, Ericsson contracts are with big telcos and long term. Lead time for these sales is very long but when they occur they are huge. But JNPR & ALU contracts are micro growth and usually single sales are not very big.

    Purely from investment point of view

    P/s of 1.2, P/B 1.9, Divi 2.3%

    I think it can easily touch 20$ from here

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Chad Henage

Chad is a self professed tech nerd and has been investing for over 20 years. He follows nearly everything in the technology and consumer goods sectors, and is a huge fan of the Peter Lynch investing style. He has over 1,000 published articles about stocks and investing. You can follow Chad on Twitter at @chadscards1274.

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