Telefonaktiebolaget LM Ericsson (ERIC) Q3 2020 Earnings Call Transcript

Telefonaktiebolaget LM Ericsson (ERIC 0.10%)
Q3 2020 Earnings Call
Oct 21, 2020, 3:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Peter Nyquist

Thank you Jerry, and good morning everyone or good afternoon everyone. And welcome to this call today, the Q3 report. With me here today, I have our president and CEO, Börje Ekholm; and our CFO, Carl Mellander. Before starting, I would like to read the following.

During the call today, we will be making forward-looking statements. These statements are based on our current expectations and certain planning assumptions which are subject to risks and uncertainties. The actual result may differ materially due to factors mentioned in today's press release and discussed in this conference call. We encourage you to read about these risks and uncertainties in our earnings report as well as in our annual report.

With that said, I would like to hand over the call to you, Börje. Please go ahead.

Borje Ekholm -- President and Chief Executive Officer

Thank you Peter, and welcome everyone to this call for our third-quarter results. We are continuing to execute on our focused strategy, and we see increasing evidence that our strategy is working, and it's reinforced by the reported performance for the third quarter. We're leading in 5G, and that's through our significant investments in R&D that's driving our global technology leadership and really enabling us to provide a cost and performance benefits to our customers. Our investments in technology leadership has also allowed us to continue to gain market share.

And it's worth mentioning that most of these gains come from non-Chinese competitors. So we're not winning here due to geopolitical situation. It's all about winning in front of the customer and delivering the best portfolio and cost-competitive portfolio they can choose. We're also seeing that we're making progress on winning in China, and we have already announced that in the second quarter, and that is a result of our increased efforts in R&D.

It is very important for us and strategically important for us to be in China, and that's because that's a global powerhouse for innovation and technological change and driven by many great entrepreneurs. We see this in many sectors, and I'm personally involved in Alibaba, and I've seen that innovative power firsthand over many, many years. No doubt, China has massive scale, but I think the entrepreneurial spirit we see there is a key driver of their success in the world today. 5G is being built out very fast in China with good coverage.

4G drove the consumer app economy. And China, the U.S. and the Nordics, they were the first countries to roll out 4G, and that allowed entrepreneurs in those regions actually to innovate on top of the network, building what has become the app economy. So it's no surprise that we see the call it the consumer app economy today dominated by Chinese and American companies.

Now, we're seeing the same thing on 5G. So building out 5G will allow Chinese entrepreneurs as well as American and whoever is first on building the network to innovate in this new space. And I do think here, it's actually important for the rest of the world, notably Europe, to take some impressions here from the fast buildout pace we're seeing in China. This will lead to, in a way, new companies being developed by entrepreneurs and innovators, and for us to be part of seeing the emergence of that ecosystem and realizing what will that drive for feature requirements in the future will be critical.

We see 5G as a huge opportunity for more call it open and global innovation, and it's built on this requirement of a high-performance secure wireless network infrastructure. And the value of running applications on top of the 5G network will be significantly higher, and it will be very similar to what we saw in 4G. So we see, in reality, 4G was a consumer drive, and 5G will now be the backbone for digitalizing the enterprises. And that's what you see us also do.

We continue to work with our service provider customers, but we're also going to build a material business for enterprise use cases. And that's to help the service providers drive more revenue growth, and that will ultimately drive more requirements and more benefit for us in network equipment. We already have a couple of offerings. IoT Accelerator being one, dedicated networks.

But during the quarter, we announced a strategically important acquisition of Cradlepoint which will allow us to build a position in wireless WAN as well. If we look at some of the highlights in the third quarter specifically, we see 5G deployments around the world gaining pace. And it's now clearly the fastest-scaling generation of mobile technology ever. We have 113 commercial contracts, 65 live networks, establishing ourselves as a clear leader in 5G.

During the quarter, we had an organic growth of 7% year over year, and that's despite the challenges we get from COVID-19. Gross margin reached 43.2% excluding restructuring, and it's improvements across all business segments. Our operating margin was 15.6% excluding restructuring costs, one of the highest for a long period of time. Our growth in China is particularly strong, and our 5G contracts are following the plan we have discussed earlier.

So now the contracts are -- or our business there are contributing to our profits in the third quarter. As I said earlier, strengthening our position in China is critical for our long-term competitiveness. We have, over the past few years, worked a lot on our cash flow generate -- or ability to generate free cash flow. If we look on a rolling four-quarter basis excluding our payment to DOJ and SEC, our free cash flow before M&A was SEK 17.7 billion.

We have also announced the plans to acquire Cradlepoint earlier in September, and that is one key building block for our enterprise ambitions. And we expect to be able to close that deal in the next coming weeks. So if we look now at the end of the third quarter, the fourth-quarter rolling margin is 10.4% which is above our target for 2020. So we feel increasing confidence of our ability to deliver on the financial targets for the full year 2020.

So let's move into the market overview. We see strong positive growth in Northeast Asia driven by gains in 5G in China. In Southeast Asia, we also saw good growth, and that's several markets contributing, most notably Australia and Indonesia. We continue to see strong momentum in North America driven by the acceleration in 5G.

Of course, the consolidation in the operating market -- operator market did somewhat lower sales in managed services as well as the legacy portfolio in digital services partly offset that growth. Europe and Latin America, that's a bit of a mixed picture. There, we see good growth in Europe on the back of market share gains. And today, you also saw that we announced the five-year strategic partnership with Telia in our home market.

That is important given our significant R&D presence in Sweden. But the progress in Europe, that was actually offset by slower sales in Latin America, and that's really driven by uncertainty related to COVID-19 and lower operator revenue leading to lower operator capex. We saw a marginal drop in -- or marginal reduction in the sales volume in Middle East and Africa. That's also a mixed picture.

5G grew at a good pace in Middle East, but again, economic uncertainty from the pandemic delayed investment decisions in some African markets. But overall, we continue to progress. And if we move over to our segments more in detail, you see that networks performed very strongly with organic growth of 13%. That's underpinned by strong growth in China as well as clearly North America.

Operating margin reached 22.7% driven by a larger share of software sales. We continue to execute on the turnaround plan for digital services, and the team is delivering well on all our plans which includes the importance of increasing software sales. So the best way to assess the progress on our turnaround plan is to look at the improvements in gross margin. And there, we reached 43.5% in the third quarter.

At the same time, we're challenged by a legacy portfolio that -- where sales are falling faster than we previously anticipated. In order to combat this, we had increased our investments in the new cloud-native 5G portfolio, and we are seeing good win ratio on our new portfolio. But it's also fair to say, it has not yet generated any significant sales, and therefore, it can simply not compensate for the fall in the legacy portfolio. On the wins that we have over the last six to nine months, it will not be recognized until 2021 in sales and beyond that, by the way.

So while we still aim for breakeven in 2021, we recognize that that can be a bit of a challenge given where we are today. In managed services, sales were down 9% organically. That's primarily due to lower variable volumes in North America. At the same time, gross margin improved to 20.1%.

And investments in R&D continue to drive new solutions and new automations that will actually have a potential to generate a much better margin profile in the future. And finally, in emerging business, we saw growth in sales and gross margin, supported by both volumes as well as cost efficiencies. But the most important part for emerging business this quarter was actually the announcement of Cradlepoint that we expect to close in the coming few weeks. With that, Carl, I give the word to you.

Carl Mellander -- Chief Financial Officer

Thank you Börje, and good morning, good afternoon everyone. So let's dive into the P&L to start with here. Net sales then reached SEK 57.5 billion. This represents an organic and FX-adjusted growth of 7% over Q3 2019, really driven by networks that grew 13% based on the continued high demand for our 5G portfolio.

And in particular, we grew in Northeast Asia with 49% FX adjusted, as Börje showed earlier, but also North America, Europe and Australia, to mention a few growth areas. Gross margin then, you see 43.2%. This is an improvement of -- by 540 basis points year over year excluding restructuring here as well. And of course, encouraging to see that all segments improved year over year with the main contribution coming from networks, but also digital services where we, in both cases, saw increased software sales.

Operating income came out at SEK 9 billion excluding restructuring charges, and this is an improvement by 38% year over year if we exclude a couple of items that affect comparability in Q3 '19. And you can see here namely the provision for the SEC, DOJ fines of course but also positive refund of social security costs last year. So this SEK 9 billion of operating income leads to an operating margin of 15.6%, where again networks is the main driver with its 22.7% operating margin, as Börje showed earlier here. Free cash flow before M&A, SEK 3.9 billion versus SEK 4.5 billion.

But here, we should also remember that we have absorbed in the SEK 3.9 billion, a EUR 2 billion capital injection into the Swedish Pension Trust. So adjusted for that, we are -- would have been at SEK 5.9 billion. And then looking at the graphs in the bottom to illustrate what Börje mentioned, you see that the adjusted operating margin after -- well, looking back four quarters rolling, it's 10.4%, well in line with the financial target for 2020 of more than 10%. So let's have a look -- closer look at gross margin, if we take the next one here.

And you see that on a rolling four-quarter basis, gross margin is now 39.6%. And this means that we are now, for the first time, if we look rolling then, above the target range of 37% to 39% for 2020. And we have seen, as you see, a steady improvement of the gross margin over 10 consecutive quarters now in terms of rolling since the start of 2018. And as we have said many times, the driver behind this is of course the investments we make in R&D.

And this clearly demonstrates the value-creation logic that we have adopted since the strategic reorientation back in 2017, that the investments in R&D to reach technology leadership creates competitiveness, and it has helped us win deals with technologically very demanding customers, but it also improves the gross margin, as we can see here. So to repeat a little bit, we saw improvement in gross margin in all segments. Software sales supported the higher margin in networks. digital services also benefited from a higher share of software.

And in addition to that, we had, in this quarter, very limited impact from the critical contracts that we have had impact earlier, for example, in Q3 2019 where we had a negative impact from those. In managed services, we saw continued efficiency gains, contributing to better gross margin also there. And lastly then, emerging business and Other, we've seen gross margin improving from 20 and a half to 30 and a half percent year over year driven by the new and emerging business part of that segment. And sequentially, you could say the main reason actually for the improvement is China.

While Q2 this year was impacted by negative margins and also a writedown in China, as we communicated before, now China turned out profitable now in Q3 and will improve further. So let's look at SG&A and R&D. And here, we see landed -- R&D then landed at SEK 9.9 billion, and this is an increase by SEK 0.5 billion, mainly following higher investments in networks in 5G. But of course, now the numbers also include the acquired antenna business which was not there a year ago.

In digital services, we also transitioned R&D funds from the legacy to the new portfolio where we invest to capture the business opportunities that we now see and that we now can capture with our 5G and cloud-native products, not least the 5G core area. In managed services, the strategy continues to be to invest in automation, analytics, AI to sharpen the offering. So that's about R&D. And then on the SG&A side, you see we came out at SEK 6 billion.

And if we compare with last year, we recorded SEK 4.9 billion, but that included the item I mentioned before, a positive refund of social cost in Sweden of SEK 0.9 billion. So if you adjust for this, the increase is SEK 0.2 billion year over year. And as we have said earlier, we are investing in digitalization and compliance in our company. And again of course we have incorporated the acquired antenna business during the year as well.

We move over to cash flow and the financial position. And here in the third quarter, we delivered then, as you see, a positive free cash flow before M&A of SEK 3.9 billion. And two items to remember here when we compare with last year. One, again, the SEK 2 billion pension trust inject -- capital injection, and this by the way completes then the SEK 3 billion injection that we have mentioned in previous reports as well.

And the second item is again the social security cost refund in Q2 '19 which had a SEK 0.4 billion positive impact on cash flow. So if you -- if we adjust for those two items, the free cash flow before M&A actually improved by SEK 1.9 billion year over year. What you also see here is that net operating assets and liabilities had a negative SEK 4.4 billion in the quarter. And this is partly driven by higher inventories following an active decision we have made to derisk the supply chain here to create improved resilience when it comes to the component supply.

But of course, we continue very high focus on working capital in the company. So this leads to a cash position that was further strengthened. You can see the number here, SEK 41.5 billion in net cash at the end of the third quarter and gross cash now at SEK 78.2 billion, also increased since last year. And as Börje mentioned earlier, on a rolling four-quarter basis, free cash flow before M&A amounts then to SEK 17.7 billion if you exclude the DOJ, SEC fine.

And that translates into 7.7% of rolling four-quarter sales. So one could say that the efforts to create a strong cash flow here in the company is bearing fruit. OK, I will round off with a few words on the planning assumptions. First of all again as usual, please refer to the full report, Page 5, I believe.

But just a few comments. First, on the markets that we operate in. Dell'Oro now expects the RAN market to grow by 8% in 2020 which is an increase from the previous number, 4%, with China then as a main growth engine at 33% growth. And the rest of the world excluding China, then is flat in 2020.

And remember, that includes then the 4% growth in North America. Secondly, based on where we stand now, year to date on the outlook, we are strengthened in our confidence that we will reach the full year targets for the group. But again, as Börje has mentioned, they needed these services, due to the weaker sales, but also our added or accelerated R&D investments, we see further -- risk of further delay in reaching the 2020 target, as mentioned here before. And then some specifics to close off then.

First of all, Q4 is normally our strongest sales quarter. If we look back historically the last three years, the normal seasonality has been plus 17% on top line from Q3 to Q4. Then importantly, I think software sales and the software share of total sales in networks is expected now to be lower in the fourth quarter after a very favorable Q3. And historically, also the share of services actually increases in Q4 compared to Q3 as we closed off the project.

opex increase normally Q3 to Q4. And looking at the last 3 years, there's been an increase of SEK 3 billion on average, but with large variations between the years. Then finally, just please note that Cradlepoint is likely to close now. And on closing then, we will pay the consideration here to the sellers, it's around $1 billion, subject to adjustments for working capital and net debt, et cetera, and we will finance that with cash at hand.

And then we will consolidate the Cradlepoint financials in the Ericsson books in the segment emerging business and Other with a certain negative impact on the fourth quarter. And with that, thank you, and I hand back to you, Börje.

Borje Ekholm -- President and Chief Executive Officer

Thanks Carl. So in summary, we see the third quarter as another solid stepping stone, and we are well positioned now to take the next steps. We're leading in 5G with 113 agreements in place and 65 live networks around the world. We see a clear link between our earnings performance and the financial performance of the company and, actually, our continued investments in R&D toward technology leadership.

We continue to increase our market share, and that's a very important part to keep scale in our business, but we're also doing that and maintaining a good cost control. With a strong cash flow that we've been able to generate, and a very stable cash flow, we're now in a financially strong position to take the next steps, and we can do that in strategic growth investments. And that's where we see a big opportunity going forward is in the enterprise segment. We think that will help drive the demand for network equipment, and it will drive demand for -- or traffic into the operator's network.

That's going to benefit us, but we also look for stand-alone opportunities in there with good economics like Cradlepoint acquisition that we think is a typical example of the type of use cases that we will focus on that both drive traffic as well as a good stand-alone economics. So with the results we've delivered so far in the year and with Q3, we are confident about our ability to deliver on the group financial targets for the full year 2020. So with that, thank you. I give the word over to Peter.

Peter Nyquist

Thank you Börje. Then operator, I would appreciate if you could open up the Q&A session.

Questions & Answers:

Operator

[Operator instructions] Our first question comes from the line of Alexander Duval of Goldman Sachs. Please go ahead.

Borje Ekholm -- President and Chief Executive Officer

Good morning Alex.

Alexander Duval -- Goldman Sachs -- Analsyt

Yes, hi. Good morning and thanks for the question and congrats on the strong results. First question, just about North America. There's obviously been discussions about spectrum auctions, and you talked about good momentum there.

I wondered if you could talk a bit about what that means for the first half of next year and just particularly interested given that tends to be a strong gross margin region. And as part of that, how you're thinking about the importance of these iPhone launches on 5G? And then second question, you talked about winning market share in Europe, and it's quite impressive, you growing there despite a declining market. And you have, in the past, talked about product advantages like dynamic spectrum sharing and the modularity of your product. So I wondered if you could give an update on the latest state of play there.

You talked about sort of broad share gains versus various players. So I wondered if you could talk about what kind of product lead do you think you have now versus let's say six to 12 months ago? Many thanks.

Borje Ekholm -- President and Chief Executive Officer

Thanks for your question. If we start with the North America. One, we see the momentum continue into next year and the demand being strong. But I would also say one more thing, when you think about the gross margin profile, we've been working quite a lot over the last few years to reduce those type of singular exposures that you referred to.

So what you see now is a much more balanced gross margin profile across the company than we've had before. And you see our growth in China this quarter, and we still have a very high gross margin development. So you have to look at it as we're a little bit derisked on the geographical mix a bit, but we see the growth continuing in North America into next year on the back of the spectrum auctions. And here, I would also say that we believe that the launch of an Apple 5G phone will actually be important to show the value of 5G for the consumer.

So we think that is going to help the demand for network equipment going forward, I would say. The -- without getting into too many details, what we see is the investments we started making already in 2017 and actually, to some extent, already before that of making our portfolio 5G-ready, enabling the launch of 5G with software upgrades has put us in a fairly unique position. That's why we have been able to launch the dynamic spectrum sharing that have clearly helped our customers to get a coverage of 5G. It's always very speculative to say how many months you're ahead.

What we need to do, we need to continue to invest in R&D to keep the distance we have. So we're going to run as fast as we can, providing our customers with new features and new functionalities that would allow them to drive their own revenue growth. And we feel that the path we're on here is what you see in Q3. It is a result of -- we gained the share as a result of our investments in R&D, and we'll continue to stick to that.

Alexander Duval -- Goldman Sachs -- Analsyt

Many thanks.

Peter Nyquist

OK, we'll move to next question.

Operator

Our next question comes from the line of Aleksander Peterc of Societe Generale. Please go ahead.

Borje Ekholm -- President and Chief Executive Officer

Good morning Aleksander.

Aleksander Peterc -- Societe Generale -- Analyst

Yes. Good morning all and congratulations on a great quarter. Could you come back a little bit on the higher software contents that you saw here in networks and digital services in the quarter? Could you be more specific as to which regions benefited the most and why it is phasing? And then more generally, on the software content, this is now the second quarter this year we had a pretty positive development in this front. And would you say that we're moving into a world where the software content is structurally higher, and this will drive your gross margins to structurally higher levels than what we've seen in the past few years? Thanks.

Borje Ekholm -- President and Chief Executive Officer

Do you want to take that, Carl?

Carl Mellander -- Chief Financial Officer

Yes, I can start at least and you can complement, Börje. But now -- but to start with, we are not talking about specific geographies here. It's more when we look at the mix between software, hardware and services that we see that the share of software was very strong in the quarter. And as you've seen planning assumptions, we say that that ratio will most likely change in the fourth quarter with software coming down and services coming up.

But we haven't decide -- or disclosed anything around specific geographies at all. I don't know, Börje, if you want to comment the structural mix, but I wouldn't say that there is a structural change in that mix. Of course, we are a big software house. In our ecosystem, software is a big part.

It's about 20%, 21% perhaps on average of our revenue. And when it comes to digital services, as one example of course one of the things we are driving, pursuing with customers is to get into more of a recurring software setup which is good for stability in that business as well. But a big structural change, I would not say so, unless you, Börje, you want to complement that?

Borje Ekholm -- President and Chief Executive Officer

No. I think it is, as part of the strategy, for example, in digital services, it is a clear ambition to actually increase our software share. So you should expect to see that go up, and that's what we see in recurring revenues as well as software revenues. So there is an element of, don't exaggerate the structural, it's not going to happen in an isolated quarter.

But that's been one of the areas that we have focused on to prioritize. So we see that happening slowly but surely. That's of course one of the reasons why you have a good gross margin development. But I think you should also remember, software sales in our business tend to be a bit lumpy.

So it comes in individual quarters, not in others. So there is an element of that as well. But we think the industry will be more of a software industry longer term. So that's critical for us to position ourselves in that.

Aleksander Peterc -- Societe Generale -- Analyst

Great. Thanks Börje.

Peter Nyquist

Thank you Aleksander. So we'll move to the next question.

Aleksander Peterc -- Societe Generale -- Analyst

Yeah, thank you.

Operator

Our next question comes from the line of Predrag Savinovic of Carnegie. Please go ahead.

Borje Ekholm -- President and Chief Executive Officer

Hello Predrag.

Predrag Savinovic -- Carnegie Investment Bank -- Analyst

Hello. Good morning to all. Thank you very much for taking my question. I was wondering if you could share some flavor on the IPR revenues and their progression in the coming years.

I understand that there are contracts of course under negotiation. But surely, your expectancy for higher figures in the coming two years, given your position in 5G and critical patents. And my second question is regarding your closing remarks there, Börje, on 5G for enterprise. With Cradlepoint now in the portfolio, you will have a more comprehensive offering for enterprise, but is it enough or do you see more opportunities for M&A or organic investments in other areas to have a more full stack offering for enterprise customers?

Borje Ekholm -- President and Chief Executive Officer

Thank you. Two good questions. The first one, on IPR, you saw that we were a bit lower in Q3 than we were in Q2. It is actually one of our licensees having lower sales volume that results in lower royalty revenues for us that we have seen.

If you look going forward, I think you should think of it as a -- it's a question of NPV of a contract with -- in every contract negotiation, it is actually a discussion about that total NPV value. And of course, what we are saying here is when we are in the middle of those discussions, we can have some temporary gaps in revenues. But we are going to accept those in order to get the fair value on our IPR agreements. So we are determined to make sure that we protect the value we have made in -- or protect the investments we have made in R&D in the contract terms we can realize with the licensors.

So we are going to be fighting hard for that, but we also say that could be gaps. So that's the way you should think of it. To maximize the NPV of the contract, we can have trade-offs or gaps in revenues. Well, if you look at the -- specifically on the 5G portfolio, we feel it's always hard to discuss the patent portfolio and how it compares.

But we see with independent assessments done by truly independent firms that have looked at the criticality of our IPR or our patents, they see that we are clearly ahead of our competitors on the strength of the portfolio. And that's what we are going to leverage in those discussions. So that's a very, very important part going forward. It's clearly a key contributor to our earnings as well, but it's the strength of our patent portfolio in R&D that drives that.

The second question?

Peter Nyquist

Enterprise.

Borje Ekholm -- President and Chief Executive Officer

The enterprise.

Peter Nyquist

If Cradlepoint is enough.

Borje Ekholm -- President and Chief Executive Officer

Yeah. The reality is Cradlepoint is one use case, wireless WAN, still very low penetration and still mostly used for I would say a backup connectivity. We think with 5G, wireless WAN can gain a much more significant penetration and be used also as the primary connection point. So we see that as a very good long-term growth opportunity, a very exciting opportunity that's going to help our customers generate more revenues, and we have a stand-alone business opportunity that's attractive.

But you're absolutely right, we think there are going to be a lot of other use cases where we will continue to invest. So that will include both organic as well as inorganic growth, but we will be building up a presence with kind of the two thought parameters or two criteria to remain the same. It has to help our customers generate revenues, and it has to be a stand-alone attractive opportunity. And here, we have the IoT Accelerator as well as dedicated networks today, but we have other organic opportunities that we pursue in parallel.

So we are very excited about this area that we see that to contribute to our long-term revenue growth in a substantial way going forward. But we'll talk more about this at the capital markets day.

Peter Nyquist

Thanks Börje. Predrag, are you happy with that?

Predrag Savinovic -- Carnegie Investment Bank -- Analyst

Thank you. Very happy. Thank you very much.

Peter Nyquist

Thank you. We will move to the next question, operator.

Operator

Our next question comes from the line of Achal Sultania of Credit Suisse.

Peter Nyquist

Good morning Achal.

Achal Sultania -- Credit Suisse -- Analyst

Hi. Good morning Peter. Good morning Börje, Carl. Just on China, I just wanted to understand I guess you've seen very strong momentum in China driven by these 5G contracts.

My understanding is that some of these contracts, the Phase 1 is getting close to completion. We'll probably have Phase 2 at some point. But how should we think about timing of Phase 2 so far? Have you got any indication from your customers? And how should we think about sustainability of that revenue strength in China going into Q4 and into next year? And then attached to that, you mentioned that China has become profitable in this quarter. Can you just help us understand at a very high level as to what's -- what are the things going on in those contracts which has allowed you to become profitable from Q2 to Q3? And further, you're saying profitability should further increase.

So is it all about mix? Is it more about scale? Like what are the key drivers for further profitability improvement in China?

Borje Ekholm -- President and Chief Executive Officer

Thank you. No, first of all, if we start with the profitability on the Chinese contracts, we already said in Q2 when we announced that they're challenged in the beginning that it would actually contribute to earnings in the second half of the year. So this is very much in line with the plan we put in place. So we're just following that.

And it has to do with your -- when you do a swap contract or a contract to build out, you're cost heavy in the beginning. That's what we saw. And now as we move into more of a -- where you kind of have -- you have some cost of course you will have that during the buildout phase. But the reality is we're getting more revenues now.

So that's the simple answer. You could have done this by bookkeeping and balancing costs, et cetera, but we think it's better to take the costs when they occur and take the revenues when they occur, and that's what you see. So you see that bit of a mismatch in the numbers, but that's also why we feel very comfortable about the development for the rest of the year on those contracts. They will further improve in Q4.

If you look otherwise, we don't see the buildout to stop in China. They will continue to build out, and they will continue to build out on the spectrum bands that we have awarded contracts now. But of course, over time, they will award other spectrum bands as well with contracts. And we'll have to compete there to seek to win there as well, and we will do so.

But we see a good demand in China, and we have no reason to think that it will not continue. And by the way, I think it's important, and this one, you may think about in a more of a European context which is that the 5G, if you think about the strategy of the Chinese operators are deploying, it's actually to build out a network because it is a platform for innovation and it's a platform for driving the rest of the economy. And we, in Europe, tend to focus more on the investments in 5G, but the reality is the value of the applications you've got to run on top of 5G is much higher. And I think that's where the Chinese operators are recognizing that and the Chinese system is recognizing that, actually incenting or driving more investments to build out the network infrastructure.

We see almost the opposite in Europe.

Peter Nyquist

Good. Thanks Börje.

Achal Sultania -- Credit Suisse -- Analyst

Thank you. Thanks a lot.

Peter Nyquist

Achal, you're good with that question? We'll move to the next question, operator.

Operator

Our next question comes from the line of François Bouvignies of UBS. Please go ahead.

Peter Nyquist

Good morning François.

Francois Bouvignies -- UBS -- Analyst

Good morning everyone. I have one quick question. You talked about the market share gain across different regions. So even if China is good, you mentioned that you gained market share in Europe and North America, for example.

Do you think -- I mean given that you have relatively high market share in those regions, in Europe and North America compared to China, do you think there is a limit to the share, I mean, you can gain in a way that your customers as well want to maintain some balance within their suppliers? So I was just wondering if you think that maybe the market share gain would be more in China and more limited in other regions would be good. Thank you.

Borje Ekholm -- President and Chief Executive Officer

I often say internally, there is a limit of 100% on market share, and I guess it applies here as well. No, for practical reasons, there are, of course -- I think our customers would like to maintain vendor diversity. We have to -- but I -- with the wins we see, we have not been at that limit yet. And actually, I think it's also worth to say that it may need type of operators like you see the announcement we made on an operator today, there is value actually of a sole supplier relationship as well because that can help our customers to lower the opex, lower their own costs, so to say, and we can provide a lower TCO to them.

So I do think it's hard to say where that limit is because in some operators, it's a clear benefit of having just one vendor in the network, where -- and it's a cost benefit, but it's also important that you can launch the same service nationwide at the same time across your whole network. So it's also a commercial benefit that customers realize that rely on one vendor. So I think there are a number of benefits here that can go in either direction of course we like to have as high as possible, so I'm not going to shy away from that.

Francois Bouvignies -- UBS -- Analyst

That's great. Thank you. And maybe a quick follow-up, if I may, on Open RAN. I mean it gains a lot of traction, discussions and also contracts within the industry.

What do you feel about the impact, maybe not for this year obviously but more in '21? Do you see an acceleration? And do you -- how it could impact Ericsson if there is an acceleration in the industry?

Borje Ekholm -- President and Chief Executive Officer

The -- what we see, it is a lot of discussions about Open RAN and the pros and cons of that. What I think is important to remember here is that we have said that we're a key contributor to O-RAN, and we will continue to be so. So we believe this is something that clearly is going to happen. So we're going to be making sure that we're well positioned.

That's also why we need to transition toward more of software revenues as well. So I don't really see O-RAN to be a major impact in the 2021-'22 time frame. But after that, I think it will start to impact the revenues for us. It will start to impact the way business models evolve going forward.

So I do think one should think of this as an opportunity where we will position ourselves as well. It's no different than other technology shifts that have happened in the industry. It's all about leading on that development and leading on that front, and then we have a very good opportunity.

Peter Nyquist

Thanks. Thanks François with those questions. We'll move to the next question, operator.

Operator

Our next question comes from the line of Sandeep Deshpande of JP Morgan. Please go ahead.

Peter Nyquist

Good morning Sandeep.

Sandeep Deshpande -- J.P. Morgan -- Analyst

Yeah, hi. Thanks for letting me on. Quickly on the network margin, I mean, when you look at your gross margin, it increased almost 500 bps year on year on a revenue increase of 6%. Maybe you can help us understand how much of that 500 bps was because of the increased scale, how much was because of the increased software and how much potentially was also a lack of services? But the other issue here is you saw a lower revenue in IPR which is a highly profitable business.

So clearly, underlying margin increased even more. So maybe you can help us understand how that margin shifted? And I have one quick follow-up on revenue.

Borje Ekholm -- President and Chief Executive Officer

When we set out our strategy in 2017, I want to tie it back to that, we said clearly that increased scale is important and increased footprint is critical for us. And that is because there are a number of very large fixed costs in this industry, R&D being one, but it actually applies in other part of our value chain as well. So volume is critically important, and that's why we have invested and continue to invest in what we call strategic contracts. We don't talk about them as much now because they're kind of part of our normal business.

But that's why we highlighted them in the past because we needed to gain scale. So what you see is the scale question is actually critical in driving this improved gross margin. So that's one thing. The second thing is we also said that R&D is a way to lower the cost.

And we do that by increasing the pace of introducing new ASICs, for example. So what we have been able to do is actually to offer today a more cost-competitive portfolio, and that's really driven by R&D investments. That is very hard to isolate each part out in our, but you see those are key contributors. Then we say that -- and you -- that's quite clear.

We have a bit more software sales this quarter than we expect in Q4 than we had last year. So that's also a factor. But I think the key drivers remain actually our call it increased scale and the lower cost here of production cost in the portfolio.

Sandeep Deshpande -- J.P. Morgan -- Analyst

Understood. Thanks Börje. And a follow-up on revenue in Europe. I mean we've seen over the last couple of months or more share shifts in Europe.

But I mean revenue from those share shifts doesn't seem to have come through in the sense that you've done better overall in Europe than the market has done. But when does the big 5G rollout start in Europe from these big share shifts?

Borje Ekholm -- President and Chief Executive Officer

The reality is if you look -- what you see, why we're growing in Europe is the share increase. But these are contracts that we won in '18 and '19. So it's not the current wins. It takes several quarters before those come through in our revenues.

So that will take a bit more time before you see all of the gains coming through. But of course, we feel quite comfortable about our situation in Europe where we see a healthy increase in market share also going forward based on already announced wins. So that is what we see going to happen.

Sandeep Deshpande -- J.P. Morgan -- Analyst

Thank you.

Peter Nyquist

Thanks Sandeep. We will move to the next question please.

Operator

Our next question comes from the line of Sébastien Sztabowicz of Kepler Cheuvreux. Please go ahead.

Peter Nyquist

Good morning Sébastien.

Sebastien Sztabowicz -- Kepler Cheuvreux -- Analyst

Yes. Hi everyone and thanks for taking the question. Just yesterday, the Swedish regulator actually has banned Huawei from 5G networks in Sweden, and this is going on a number of countries, all are doing this. And so basically, do you see any risk on your market position in China on 5G if sometimes Chinese government decide to retaliate against European vendors? This would be the first question.

The second one is the higher software sales in Q3 and the lower software sales expected in Q4, is it linked to your dynamic spectrum sharing deployment? Could you come back a little bit? How do you see this technology being vectored into those days? Is it something that positively contributed to Q3, notably in the U.S.? Thank you.

Borje Ekholm -- President and Chief Executive Officer

It's a very speculative question on bans, non-bans and geopolitical situation. And it's -- I think it's fair to say that countries have to decide on the geopolitical situation, national security on their own. And that's something we let them do. We focus instead on doing what we can and what we can impact.

And what we really can impact is actually the competitiveness of our portfolio, providing our customers with the right features and right products. And if we can continue to do that that's going to allow us to be much more successful as a company. And the reality is we thrive in a situation where there is competition. Competition drives out the best from us.

We will be more innovative. We provide better solutions to customers. So I welcome that we have competition and that we have a global competition. The reality is the cellular market is different from most others.

So of course, like Huawei, it's actually one of our fiercest competitors around the world in the product market. At the same time, we cooperate when we drive the 3GPP standard. And the reality, this type of competition/cooperation is what has allowed the cellular industry to connect 8 billion subscribers around the world. So today, we're free to travel to any country in the world, with some very few exceptions, and we can connect our phones.

That's something that comes out of a very healthy ecosystem that's driven between competition, on the one hand, and cooperation on the other hand. And we think that is something that will continue and should continue. So we certainly hope that for the rest of the world, so to say, that we actually can continue cooperate and compete at the same time. And we need to be innovative.

When we face that type of competition, we need to be more innovative. And it's the only thing that we can impact as a company. So we try to focus on that and work on that. The other question, on the software revenues, they are always going to be a bit lumpy between quarters.

That's the way it is. Of course, our success on dynamic spectrum sharing is a key reason why we have software revenues. And we've said it all along, we have our hardware being 5G-ready, so it's all about the software upgrades. And in a way, that's what we get paid for.

Then Q4, it's also -- it's historically always much higher ratio of service revenues. So if service revenues go up, something has to go down as it can only add up to 100%. So that's why you are going to see a bit lower proportion of software revenues.

Peter Nyquist

Thanks Sébastien. And operator, we are now ready for the last question now please.

Operator

Thank you. Our last question comes from the line of Amit Harchandani of Citigroup. Please go ahead.

Peter Nyquist

Hi Amit.

Amit Harchandani -- Citi -- Analyst

Thank you. Good morning all. I'm Amit Harchandani from Citi. Two questions, if I may.

My first question relates to how you're thinking about 2021, please. You talked about, I believe, North America growing into 2021. And I was wondering, given that we are already close to the end of this year, if you could share your visibility into 2021 and what you expect the market growth to be and whether you expect yourselves to outperform the market? So any thoughts about visibility across regions into 2021. And secondly, if I may, going back to the question on margins.

We've seen strong margin performance coming through. And despite FX headwinds, despite a ramp in China, despite lower IPR, you have clearly delivered upon some of the investments made in R&D. So as we think about the secular margin profile of the company, I know we have an ambition for 2022, but is there any reason why we, as the financial community, shouldn't start getting more excited about you getting to the higher end of the margins and whether these targets could potentially turn out to be conservative? Thank you.

Borje Ekholm -- President and Chief Executive Officer

I think I will let -- have Carl to respond to those questions.

Carl Mellander -- Chief Financial Officer

I thought so. But Amit, when it comes to 2021, I mean you know that we have not -- we're not guiding specifically, and I think it's a bit early to look into '21. But of course, we do have a strong position in the market. We do see market share gains, as we have been talking about.

And of course, 2021 is on the road toward the 2022 target which we stick to, as you know. Then we have flagged for a couple of things including the -- what Börje talked about before on IPR which could lead to a temporary gap in revenues there. But we think that's manageable. But in general I would say we see growth coming from market share gains, not least in Europe.

The overall RAN market growth in 2021, according to Dell'Oro, is 2%. And of course, our ambition is, given the market share gains and the strategy we have and the scale aspect that Börje talked about, our ambition is obviously to grow faster than that. China will continue in the deployment, as mentioned as well before, and we expect that to grow. And North America, finally, I mean very good and continued momentum also next year.

So that's how we look at that. And excitement is good, on your second question. Of course, excitement about Ericsson and opportunities is always good. But remember, when we set the targets back in 2017 for both 2020 and then 2022, refined a bit during the journey here, I mean many people didn't at all believe that we would reach them.

Now we are closer to the end of 2020, and we have greater confidence that we will reach those. And then we shift focus to of course reaching the 2022 targets. And for the more long term, I think we also come back to that perspective on the capital markets day in -- on the 10th of November.

Borje Ekholm -- President and Chief Executive Officer

And you know what's important, just to add, is we are always focused on driving a long-term successful Ericsson. So during this phase from '17 to today, we've been focusing on making the long-term investments to strengthen our long-term competitiveness. So for us, we -- I will be honest to say, we're not going to focus on 2020 or 2021 or 2022, but those are important milestones to showcase our ability to deliver. But we are really focused on the 2025 and beyond time frame.

And that's why we're also extraordinarily optimistic about our positioning in the market where we see that we are gaining footprint on our network, but we're seeing that we're gaining footprint on 5G core and our orchestration offerings. So we're seeing great progress there. But all of that is really there only to make sure that 2025 and beyond, we're an even stronger company.

Peter Nyquist

You are good with that Amit?

Amit Harchandani -- Citi -- Analyst

Thank you, yeah.

Peter Nyquist

Thank you. So before handing over to Börje's closing remark, I just want to repeat what Carl said about capital markets day on the 10th of November. But also, actually, we have the update from the markets coming up next week, Thursday and Friday. So please be aware and tune in then at the next week's Market Areas update and the capital markets day on November 10.

By that, I would like to hand over to Börje for the closing remark.

Borje Ekholm -- President and Chief Executive Officer

Thanks, Peter. So just as an ending, I want to thank you for your time today, and thank you for very good questions. What we see is that our strategy to invest in technology leadership is clearly paying off, and we are now winning share in a highly competitive market. We believe that 5G will be a critical platform for digitalizing enterprises.

Basically, there will be no digitalization without mobility. And we are well positioned in mobility to develop the enterprise use cases like we do with Cradlepoint and dedicated networks and our IoT Accelerator, and we are convinced these will provide us with the long-term growth potential that's going to be very attractive. We will discuss those plans much more in detail at the capital markets update next month. And hopefully, as many of you as possible can join that event.

So once again, thank you, everyone, for dialing into this telephone conference. Thank you.

Carl Mellander -- Chief Financial Officer

Thank you.

Duration: 62 minutes

Call participants:

Peter Nyquist

Borje Ekholm -- President and Chief Executive Officer

Carl Mellander -- Chief Financial Officer

Brje Ekholm -- President and Chief Executive Officer

Alexander Duval -- Goldman Sachs -- Analsyt

Aleksander Peterc -- Societe Generale -- Analyst

Predrag Savinovic -- Carnegie Investment Bank -- Analyst

Achal Sultania -- Credit Suisse -- Analyst

Francois Bouvignies -- UBS -- Analyst

Franois Bouvignies -- UBS -- Analyst

Sandeep Deshpande -- J.P. Morgan -- Analyst

Sebastien Sztabowicz -- Kepler Cheuvreux -- Analyst

Amit Harchandani -- Citi -- Analyst

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