Foolish Forecast: Investors Underestimate Ericsson

Ericsson (Nasdaq: ERIC  ) reports fourth-quarter earnings Friday morning. The telecom equipment king has stumbled badly in recent months. Let's see whether those missteps have made the stock a bargain or a time bomb.

What Fools say:
Here's how Ericsson's CAPS scoring rates against some of its peers and competitors.

Company

Market Cap (Millions)

Trailing P/E Ratio

CAPS Rating

Nokia (NYSE:NOK)

$133,800

12.8

****

Siemens AG (NYSE:SI)

$116,760

8.5

*****

Ericsson

$35,680

8.8

***

Motorola (NYSE:MOT)

$25,700

N/A

**

Alcatel-Lucent (NYSE:ALU)

$14,160

N/A

**

Data taken from Motley Fool CAPS on 1/30/08.

There are only two negative CAPS comments on record for this stock, both from the time of a massive sell-off after the third-quarter earnings report in mid-October last year. One simply notes the overnight 23% share-price drop, and the other talks about "symptomatic problems with ERIC which are not likely to correct themselves until some internal reorganization takes place."

On the other hand, the bullish comments are plentiful, and almost all of them center on a single theme: The haircut got too close to the scalp, but the hair is sure to grow back. Oversold. On a rebound. Undervalued. You get my drift.

What management says:
Therein lies the rub. According to CEO Carl-Henric Svanberg, the third-quarter miss was due to "a shortfall in sales in mobile network upgrades and expansions which resulted in an unfavorable business mix that also negatively affected Group margins."

"All other businesses performed as expected," he continued. "The effect of market dynamics is always a matter of judgment. This quarter we have underestimated the effects."

Those are the words that sent the stock into a tailspin from which it has yet to recover. Operating income took a 36% dive year over year, because Ericsson's customers were more interested in rolling out entirely new networks than in upgrading their old ones. The upgrades carry significantly higher profit margins for the company.

What management does:
When gross margins dipped in the third quarter, the economies of scale that make Ericsson tick broke down for a moment, with negative effects cascading down the income statement. Is this a permanent state of affairs? We'll see about that in a minute.

Margins

6/2006

9/2006

12/2006

3/2007

6/2007

9/2007

Gross

43.6%

43%

41.2%

41.2%

41.3%

39.7%

Operating

17.7%

17.9%

15.4%

15.5%

15.5%

12.9%

Net

14.5%

14.6%

14.8%

15.2%

15.4%

14%

FCF/Revenue

7.5%

9.5%

8.2%

8.9%

11.5%

7.9%

All data courtesy of Capital IQ, a division of Standard & Poor's. Data reflects trailing-12-month performance for the quarters ended in the named months.

One Fool says:
Ericsson has been diversifying into IPTV infrastructure equipment over the past year through a couple of acquisitions. That's an important hedge for the future, since the bread-and-butter phone networks eventually will become old hat when the developing world is blanketed in 4G mobile signals and beyond. We're still years away from that tipping point, but you should keep an eye on the IPTV market, because serial innovator Motorola is a big player there, along with a Cisco Systems (Nasdaq: CSCO  ) that likes to plan for the next-next-next Big Thing as far as 10 years out. But that's a positive for the far future.

Today, we have to decide for ourselves whether the product-mix issues are permanent or merely fluky. Management takes the prudent, cautious view that "the current conditions will prevail." There is probably some truth to that assumption, because global markets rarely flip-flop overnight between install and upgrade cycles. But it's also hard to believe that Ericsson's market opportunity is more than 40% smaller today than it was before the last report, as the share price would indicate.

In all, I'd expect somewhat stronger margins this time, along with an updated and less gloomy outlook for 2008. The stock won't suddenly regain all the ground it lost, but every journey starts with a single baby step. And I'd be willing to take that long, slow ride, because we're long-term investors here at Fool HQ.

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